KKR Real Estate Finance Trust Inc. Q2 FY2021 Earnings Call

Good morning, and welcome to the KKR Real Estate Finance Trust Inc. Second Quarter 2021 Financial Results Conference Call. I would now like to turn the conference over to Jack Switala. Please go ahead.

Thank you, operator. Welcome to the KKR Real Estate Finance Trust earnings call for the second quarter of 2021. We hope that all of you and your families are safe and healthy. As the operator mentioned, this is Jack Switala. Today, I'm joined on the call by our CEO, Matt Salem; our President and COO, Patrick Mattson; and our CFO, Mostafa Nagaty.

Thank you, Jack. Good morning, everyone, and thank you for joining the call today. In the second quarter, we harnessed the power of the KKR origination franchise to originate 8 loans for $967 million. We have an additional pipeline of approximately $850 million in loans, which have either closed or are under exclusivity subsequent to quarter end. We also delivered another outstanding quarter of financial results with distributable earnings of $0.54 a share, covering the $0.43 dividend by 1.3x. Our earnings continue to benefit from strong credit performance, existing LIBOR floors and net portfolio growth. In today's active origination environment, KREF is benefiting from its position as the flagship transitional senior commercial real estate loan strategy inside of a global asset manager with an established real estate platform. We have unique access to economic views from our global macro team and real-time market and property-level information from our partners in the real estate equity team. This market connectivity is supporting a real estate credit franchise that has grown meaningfully. For perspective, at the end of 2019, our real estate credit franchise was comprised of 24 investment professionals compared to 46 today. This origination engine will be critical as we continue to see good progress on our sponsors' business plans, which we expect to lead to elevated repayments in the third and fourth quarters.

Thank you, Matt. Good morning, everyone. As of quarter end, a market-leading 76% of our asset financing remains fully non-mark-to-market, and the 24% remaining balance is only subject to credit marks. This is similar to the financing mix we had at the onset of the pandemic, which has served us well over the last 18 months. As of quarter end, our debt-to-equity ratio and total leverage ratio dropped slightly to 1.9x and 3.3x respectively. Following the success we had in the April raise of $167 million in net proceeds, perpetual preferred stock at a fixed-for-life cost of 6.5%. We continue to focus on optimizing our financing. This last week, we announced a new $1 billion CRE CLO. The offering was well received, allowing us to upsize by 30% and priced the $1.3 billion transaction on Friday. The CLO features a 2-year reinvestment period with an 84.25% investment-grade advance rate at a weighted average running cost of capital of LIBOR plus 1.3% before amortized expenses. In conjunction with this transaction, we'll call our first CLO, but the larger size of the new deal will increase the aggregate amount of matched term financing on a non-mark-to-market and nonrecourse basis. The combination of our brand, high-quality loan portfolio and track record as a manager positioned us to achieve this attractive financing with a market-leading cost of capital. As we have discussed in the past, we have a robust quarterly asset review process, and we evaluate every loan in the portfolio to assign a current risk rating. The current portfolio risk rating of 3.1 on a 5-point scale is consistent with the weighted average risk rating last quarter. Notably, 90% of our loans are now risk rated 3 or better, up slightly from last quarter. There were no changes to the composition of the watch list in the second quarter. However, we are seeing improving trends in properties, which may lead to positive credit momentum in other assets. In the second quarter, we saw $27.6 million in pay downs on our New York condo loan. On our Brooklyn hospitality loan, occupancy rates ticked up nicely in the second quarter to 77% relative to occupancy rates of 53% in the first quarter. Our Queens industrial loan is approaching its next maturity and will most likely provide a short-term extension to allow the sponsor to finalize their sale process. As a reminder, we believe we have adequate CECL reserves with respect to our watch list loans and the broader portfolio. If a credit event does occur and a loss is crystallized, it will flow through our distributable earnings, but we would not anticipate a meaningful impact to GAAP net income or book value.

And our first question will come from Jade Rahmani of KBW.

I appreciate the detailed commentary. Starting with the dividend, you mentioned distributable EPS running 30% ahead of the current dividend. Then you mentioned your expectations regarding repayments, which would be elevated as well as a normalization over time in the net interest income margin. So I was wondering if you think, once things normalize, there could be room for an increase in the dividend? And if there were excess distributable earnings, is it your expectation that for this year 2021, there could be a special dividend?

Jade, it's Matt. I appreciate you joining the call, and thank you for the question. I'd say right now, we're focused on just the current dividend. Obviously, we'll readjust that after we meet with the board in future quarters. But from everything we see now, especially given the low interest rate environment, I think our target is still trying to meet the current dividend.

And based on where distributable EPS has been running, do you think there's excess retaxable earnings that might require a special dividend?

Not at this point. We're not really focused on a special dividend. I think there are a number of factors that we'll take into consideration towards the end of the year as we meet with the board, but certainly, we haven't focused on that yet.

The $1 billion of repayments you expect in each quarter for the third quarter and the fourth quarter, would that produce early prepayment income?

We'll have some pull forward on the OID to the extent they're prepaying before their initial maturity, which we expect. So that will generate a little bit more income. Most of them have run through their prepayment penalties or other call protection we may have in place, but you can get a little bit of that OID. So yes, that can drive earnings. Obviously, we don't originate a loan on the exact day it pays off. So there will be some cash drag associated in the interim with a heavy repayment schedule as we ramp up and meet that with our new originations.

Lastly, just on credit. Could you give an update on the Portland retail loan? What's your expectation for that loan over the next few months?

Yes. Happy to. I think we're making good progress there as it relates to working with the next sponsor and the next phase of that investment. Our goal is to hopefully come back to you next quarter with a broader update on where we stand. So stay tuned on that one.

So you say next sponsor, has the property gone through foreclosure? Or what is the current status?

No.

I know it's on non-accrual.

No, it's the same status. It has not been foreclosed on and taken to REO. We're in the middle of all those discussions right now.

The next question comes from Steve Delaney of JMP Securities.

Matt and Patrick, I was wondering, we've been through so much with COVID and the demographic shifts that it has highlighted. As your equity group, number one, and then your sponsors that you're lending to, are you seeing any type of definitive shifts into what geographic markets capital is flowing from the real estate equity side specifically? And are there any markets that - how dramatic is that? It's kind of what we hear about the license plates in Texas and things like this. Maybe just give us a sense for where the money is going from the real estate equity side, and on the other side, where it is not going.

Yes. Sure, Steve, it's Matt. I can take that, and thank you for the question. I think that if you think about what COVID did, it accelerated some things and it dislocated some of the market. Certainly, in the geographic aspect you're asking about, there has been some pretty significant acceleration in the growth markets, particularly in the southeast and certainly some of the tech cities. The capital going into that is quite pronounced. I mean, it's very tangible. And we've seen good leasing velocity in those markets still for multifamily or office. Again, it was a theme before COVID, but it has been accelerated, and we will continue to focus on those markets from a lending perspective. We're very active on the real estate equity side as you would suggest. We mention in our commentary every quarter that the power of being able to sit alongside that and underwrite deals together and get market information in real-time is very powerful.

Are there any markets that - we all hear about Austin, right, and Phoenix and Denver in those places? Are there any sleeper markets emerging that maybe aren't on the tip of everybody's tongue?

I mean nothing that's not obvious. I mean, Charlotte, I wouldn't call that a second-tier city, but Charlotte is obviously another growth area. The Florida markets also have a similar theme pre-COVID, but I would say those are particularly strong as well; the Southern Florida markets.

Yes. I should probably use the term 'non-gateway' rather than describe them a little better. Okay. And then just to close, the comments about the portfolio. We were $6.5 billion at June based on the commentary about pipeline and closings. I mean, it seems to me that we should just model essentially a flat portfolio over the second half of the year. Does that sound reasonable to you?

Steve, it's Patrick. That's right. I think that as we think about the course of the repayments here and our origination capacity and our ability to match that, we're assuming that we're going to be in that $6 billion area for the portfolio size.

Yes. Got it. I understand it can be lumpy month-to-month as we go through that in the next 6 months.

The next question comes from Stephen Laws of Raymond James.

To follow up on Steve's question, a good spot for me actually. As we think about redeploying that capital, Patrick, can you touch on anticipated cash drag? I mean, I want to make sure I don't overestimate my interest income just using spot quarter-end leverage. Does it take 2 weeks to turn over the capital with roughly 1/3 of the portfolio, I guess, turning over the next 6 months? I'm curious how we should think about cash drag or average leverage through the quarter or how you would term that?

Steve, thanks for the question. Yes, I think that's right. We're trying to highlight that if you looked at the past couple of quarters, we haven't had a lot of turnover. So we've gotten the benefit of collecting a full quarter's interest on a robust portfolio size here. As we think about the latter half, there is going to be some amount of drag. It wouldn't be unreasonable to have a month gap between some of those repayments and when new closings come. It's difficult to quantify it because it depends on the time lag, but we expect there to be something. For modeling, I'd certainly factor in some amount of drag.

Great. That's helpful. On your comments in the prepared remarks, Patrick, on the CLO, I think, close to 2018, FL1 being called, can you give us a number on the transaction expenses that are going to hit in Q3? Onetime, I assume that it will go into the quarter. And then I would think we would add that number back for distributable earnings, but can you talk about the onetime expenses around the CLO call?

Sure. Steve, as it relates to the FL1 transaction, all of those deferred financing costs have been amortized through. We actually didn't incur any in the second quarter, and when we closed the transaction in the third quarter, there'll be nothing that has to get accelerated. The only thing that will happen is that upon closing, we'll have a set of costs that will need to be amortized for the new transaction that will need to be factored in. There's no drag from calling the first deal.

Great. And Matt, one for you. Just did the preferred equity raise, kind of you've got some converts outstanding. You've got an ATM available that you haven't used. And certainly, with the stock above equity, you could raise capital to be accretive to book. I know there's a lot of turnover coming in the next 6 months, so probably less relevant. But how do you think about your capital stack, what the right mix is, and how you look at the market for the cost of capital for those various options?

Yes. Thanks, Stephen. Happy to take that one. Having diversified options, especially as it relates to the equity, has been quite powerful. We were able to access the preferred equity market at a moment where it wasn't really accretive from a common equity perspective, and we had a big pipeline. We thought that was particularly attractive. As we grow from here, we're looking at both the common and preferred as good options. We need to keep the sizing appropriate for those. That being said, to highlight your comment, with the repayment pipeline we have, we are probably a little bit more focused on using our origination pipeline to fund those repayments. The need for equity currently is relatively low. Now that can change if our pipeline grows or if these repayments are pushed out a bit, we may need it. The pipeline side of the equation is very high right now, but again, so is the repayment.

The next question comes from Don Fandetti of Wells Fargo.

Matt, there's a striking increase in occupancy at your Brooklyn hotel, which clearly reflects New York coming back. I was just curious about your current thoughts, just given the delta variant, in terms of interest in putting capital to work in New York. Are there a lot of opportunities that you're seeing in the area? Obviously, your watch list had several New York properties. So maybe you're talking some of that as well.

Well, Don, thanks for the question. As it relates to the delta variant, we're monitoring it very closely. Our first thought is to our employees' health and safety. We're watching it from that perspective. We are in the office working together, so we want to make sure we're on top of it. As it relates to the portfolio and investment risk, clearly, it could have an impact on the cyclical nature of the hotels. However, we've seen our portfolio through the depths of the initial COVID volatility be quite resilient. While we will watch it, it's not making us overly concerned for our existing portfolio. I would say on the New York City comment, we've seen a significant increase in activity in leasing. Not only at the hotel in Brooklyn but also through the multifamily properties that we've had. Over the course of the last year, we've had some substantial repayments in our multifamily portfolio in the other Tri-state region. We are still interested in this market and are looking for good opportunities.

And I saw that you did a single-family housing loan in the quarter. I was just curious about your thoughts on that market. Do you think you'll be more active there, or was that a one-off?

Yes. No, it's a good point to bring up. On the real estate private equity side of our KKR business, we're very active in all things housing. We have a single-family rental equity platform there, so we're very familiar with the sector. The need for housing is quite dramatic, and you've seen that sector really become institutional ownership. In this particular case, we are servicing one of our existing institutional clients that is in that business, and we did it out in Phoenix, which is clearly a growing market. I wouldn't call it a one-off. We like this sector, and we would like to do more. We are seeing a number of attractive opportunities. I'm not sure how big it will be as a part of the portfolio because commercial banks are very active in that sector. It's unclear how much of the opportunity set they will take versus lenders like ourselves. However, it's something we're following and hope to do more of, but unclear how big we can grow it.

The next question comes from Rick Shane of JPMorgan.

I'm curious when you think about the dividend policy and we look at the impact of floor income. Obviously, there is a potential headwind as rates rise, but you guys are also talking about $2 billion of repayments in the second half of the year. I'm assuming that brings us effectively moves us along that floor income scale as you lose a lot of floor income. How much is that impacting the dividend policy?

Rick, it's Patrick. I'll take that one. As we think about what's likely to transpire over the next couple of quarters, we think that repayments will be elevated. As Matt indicated, we'll get some pull-through on OID acceleration for those quarters. However, we will start to lose some of that excess NIM that we've been able to capture through the LIBOR floors. The flip side of that is that we're setting new loans at coupons that are almost entirely spread because spot LIBOR is at less than 10 basis points, which means that we're earning all of that income to spread. We set ourselves up well for the coming years. It's difficult to quantify exactly the change or the quantum. A lot will depend on the timing and which loans actually repay.

Got it. Okay. And one of the things that's interesting is - and again, this is very back of the envelope math, but if we compare the percentage of loans in the first quarter, which was 69% with floors above 1%, and the percentage this quarter, which I believe is 57%. It looks like there was about a $465 million decline in loans with 1% LIBOR floors, but that's substantially above the repayments that you guys experienced during the quarter. So I'm wondering, are there loans that are being renegotiated to reduce floors? Is that something we need to consider as well?

Yes, Rick, you highlight a good point, and that's a very detailed point that you're pulling out. There have been some instances where loans have come up to initial maturities or as we've provided any form of accommodation to the sponsors, we've recast the coupon. In a lot of cases, the coupon has stayed the same, but the mix of LIBOR and spread has changed. Where we previously had a varying money floor, we reset closer to a spot LIBOR and took the remaining income in spread just to ensure that if the loan is extended longer, we're going to benefit from an increasing LIBOR rate. That's a good find, and certainly something that we have been focused on.

Got it. So that is actually long term, and I apologize for the second follow-up question, but that ultimately should turn into slightly wider spreads. That's the trade-off you're getting by giving up some of that floor?

That's right. Wider spreads, and you can see that in the loans we're making relative to some of the loans that are paying off. One last thing I would highlight here is if you look quarter-over-quarter, over the last several quarters, we started the year with our weighted average coupon at about 4.8%. It's gone down about 10 basis points in the last 2 quarters, but still at 4.6% is a strong number relative to our cost of liabilities.

The next question comes from Tim Hayes of BTIG.

A lot of my questions have been asked and answered, but maybe a couple more. In the pipeline, I think you mentioned about $850 million of loans closed or under exclusivity since quarter end. Can you provide a little color there on LTVs and spreads and how that compares to what you closed in the previous quarter? And I think you talked about seeing more construction loans in your pipeline as well. I'm wondering, if all $850 were to close this quarter, what are the expectations for fundings at closing for those loans?

Jim, it's Matt. I can provide a bit of color around that. The pipeline is consistent with what we've been doing in the past. There is some construction in our current pipeline. There's life science, so some of the newer sectors that we're looking at. I don’t have the exact breakout of committed versus expectations around initial funding in front of me, but I would expect something in line with the current quarter. We do have some construction components in that origination pipeline. The market has been pretty consistent the last few quarters in terms of spread and competitive dynamics. Depending on the property type and whether construction or not, I would say our coupons are largely in line with what we did this past quarter.

Got it. That's helpful. Matt, from a high-level perspective, what percentage of the portfolio consists of construction loans today? Where do you see that going? I know that your level of unfunded commitments jumped up a bit this quarter, I think it's at about 13% of the total portfolio. Where do you feel comfortable with that number going to? Your liquidity position seems pretty solid today, especially considering the expected repayments over the next couple of quarters, but the pipeline is solid too. Just wondering if you feel good about where your liquidity is today relative to your pipeline and unfunded commitments?

Yes. I'd note that much of the construction we've done to date is in the industrial sector, so that will move into the ground quickly. It's not going to be out there for long. It's almost like forward originations for the next couple of quarters. In terms of the size today of our construction budget, it's pretty small, less than 5%. We still have a ways to go before we would hit anything that would raise concerns from risk management or portfolio management perspectives. There's just a lot of activity in that particular market today, especially concerning e-commerce demand in the industrial sector. We'll continue to focus on it over the next couple of quarters if the returns align with our expectations. However, I understand your point around managing future funding vis-a-vis the overall company's liquidity.

Okay. Finally, on the industrial sector, you highlighted how active KKR is there and the resources that bring. I think we've heard that it’s not always easy for you to find industrial loans given the size you're focusing on versus where that market usually tends to be. How big do you see that segment becoming as a percentage of your portfolio over time? If it’s easier to find those loans given the KKR footprint? What impact should that have on ROE, given that it's a competitive asset class?

Right. It's a good point. Historically, it's been difficult to drive overall volumes and portfolio allocation to industrial given their granularity. A couple of points: One, we're seeing larger opportunities. Amazon and some of the other big e-commerce players do have bigger footprints, creating a need for larger loans. One deal we did this quarter was on smaller boxes, but we tackled it on a portfolio-wide basis, effectively financing a whole year's pipeline for a national developer. In terms of our portfolio, round numbers at $5.5 billion, could we see it grow into the low double digits? I think that's possible, but it won’t be our largest exposure by any stretch. From an ROE perspective, we're doing these slightly more accretively than what we do in multifamily loans. Overall, it may be slightly additive, but I wouldn't think about this as really driving the entire ROE of the business. Just view it as if it becomes a 10% part of the portfolio, it’s earning slightly more than many other sectors we're lending in.

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

Great. Thanks for joining, everyone. Please reach out to me or the team if you have any questions. Have a great day.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.