KKR Real Estate Finance Trust Inc. Q3 FY2022 Earnings Call

Good morning and welcome to the KKR Real Estate Finance Trust Inc. Third Quarter 2022 Financial Results Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Jack Switala. Please, go ahead.

Thanks, operator, and welcome to the KKR Real Estate Finance Trust earnings call for the third quarter of 2022. 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, Kendra Decious. 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. Please refer to our most recently filed 10-Q for cautionary factors related to these statements. Before I turn the call over to Matt, I'll provide a brief recap of our results. For the third quarter of 2022, we reported GAAP net income of negative $48.4 million or negative $0.70 per diluted share. Distributable earnings this quarter were $34.4 million or $0.50 per share. The rising interest rate environment served as the primary driver behind our strong distributable earnings, supporting a dividend coverage ratio of over 1.1 times relative to our $0.43 per share Q3 dividend. Book value per share, as of September 30th, 2022 was $18.28, a decline of 5.6% quarter-over-quarter. This was driven by an increase in our CECL allowance by $1.16 per share to $1.66 per share. This increase was primarily driven by higher reserves on watch list loans. Finally, in September, we paid a cash dividend of $0.43 per common share with respect to the third quarter. And based on yesterday's closing price, the dividend reflects an annualized yield of 10.2%. With that, I'd now like to turn the call over to Matt.

Thank you, Jack. Good morning, everyone, and thank you for joining us today. KREF generated another quarter of strong distributable earnings of $0.50 per share which equated to greater than 1.1 times dividend coverage ratio. Our earnings continue to benefit from rising interest rates, and we expect further increases in base rates to serve as a tailwind for KREF's earnings heading into the fourth quarter and 2023. To put this in context, we have stated in our supplement that a 100 basis point increase in base rates, from 3.04% at quarter-end, would result in an increase of $0.21 in annualized distributable earnings per share based on our portfolio, with all else being equal. The forward rate curve is projecting more than 100 basis points of increases, with 55 basis points already realized to date. The macro environment has continued to deteriorate, which has caused a corresponding negative impact on commercial real estate values. This was further accelerated by the September Federal Reserve Meeting. Real estate values are declining in real-time as the market digests the higher cost of capital, combined with potential selling demand in a recession. KKR's integrated real estate business, which manages over $60 billion of AUM, affords us a robust view of the current operating environment. While valuations are changing, fundamentals across most of our portfolio remain strong, characterized by high occupancy and rent growth. Nearly half of our portfolio is secured by multifamily, and another 19% is in the high-growth segments of industrial and life science. Over 70% of our 2022 originations are secured by either multifamily or industrial properties. However, 27% of our portfolio is secured by office properties, and this sector has the added risk of uncertainty around long-term tenant demand given work-from-home preferences. Over the past quarter, we have witnessed a significant decrease in liquidity in the office sector, as well as capitulation by owners. In response to this, we have materially increased our CECL reserve and added three loans to our watch list, for a total of five loans. In addition, we now have two loans which are risk-rated at 5, and have increased our dialogue with those sponsors. We will use our extensive experience across our KKR platform to optimize these resolutions. I'll conclude my comments by discussing our market positioning. KREF was built for times like this. Our conservative lending strategy is concentrated in growth property types and geographies, owned by institutional investors. Our portfolio is financed with best-in-class non-mark-to-market facilities. Since the beginning of the year, we have been transitioning to a more defensive posture. To highlight a number of steps we have taken, we raised approximately $345 million of net primary proceeds through common and preferred equity offerings as well as our AGM program. We increased our revolver by $610 million, extended its term to five years, and added nearly $2.5 billion of non-mark-to-market financing year-to-date. We currently stand at 76% of total outstanding secured financings, leaving us today with over $900 million of liquidity, which does not include $370 million of unlevered senior loans on the balance sheet. While this market has a favorable lending environment, we will continue to operate KREF with lower leverage and higher liquidity, and anticipate only originating loans to match repayments. With that, I'll turn the call over to Patrick.

Thank you, Matt. Good morning, everyone. I'll focus today on our efforts on the capital and liquidity front, and provide an update on our CECL reserve and watch list loans. As discussed in the past, creating a diversified liability structure built on non-mark-to-market financing has been a top priority for KREF. I am pleased to note that, since the beginning of Q3 last year, we have added over $4 billion of non-mark-to-market financing capacity, including two CRE-CLOs, five bespoke facilities, an upsize of our secured term loan B, and an extension and upsize to our corporate revolver. Specifically in the third quarter, with the help of our partners and KKR Capital Markets, we entered into a new $266 million bespoke nodal note financing facility in connection with one of our loan originations. Additionally, we completed a second upsize on one of our existing match term financing facilities, from $750 million to $1 billion. Subsequent to quarter-end, we closed a new $125 million match term non-recourse facility. Importantly, as of quarter-end, 76% of financing remained fully non-mark-to-market. The resilient financing we developed, much of which has been done on a bespoke basis, buffers us during times of capital market volatility. Alongside the fully non-mark-to-market features associated with these structures, we've also achieved an attractive cost of capital relative to other means of financing that can be sourced today. As the CLO market has cooled over the past nine months and the spreads in the CLO market have widened, our mix of alternative sources of financing away from some of the more public capital market sources remains a major differentiator for KREF. In terms of capital management strategy, KREF is preserving flexibility and operating at the lower end of our target leverage range given the broader market backdrop. Our total debt-to-equity ratio was 1.9 times, and total leverage ratio was 3.6 times as of quarter end. We expect to maintain total leverage in the mid-3s over the coming quarters. Our approach to managing the balance sheet allowed us to start the fourth quarter with a record level of liquidity in excess of $900 million. Additionally, at quarter end, KREF had $370 million in unencumbered senior loans on the balance sheet. Turning to our CECL reserves and watch list, this quarter, we recorded an increase in our CECL of $81 million to $115 million or 156 basis points based on the funded loan portfolio. The change in reserves is unrealized and non-cash; it does not reduce distributable earnings in Q3. However, if such amounts are deemed non-recoverable in the future, we would recognize a loss to our cash metric of distributable earnings. We have five loans on the watch list as of quarter end; all of which are secured by office properties. Consistent with past quarters, we highlight those loans in our earnings supplement. New loans were downgraded to a risk rating of 5 and account for nearly half of the $115 million in total CECL reserves. We have not disclosed the individual CECL reserves around the 5-rated loans to avoid disadvantage in discussions with our sponsors and other market participants. Some details of the 5-rated loans: First, the Philadelphia loan is secured by a $4 billion portfolio comprised of approximately 600,000 square feet of office and includes a 500-space parking garage. Recovery from the COVID-19 pandemic and the return to office in the Philadelphia market has been relatively slow compared to some other major U.S. cities. Current occupancy at the property is approximately 50%, down from the low 60s at closing. The loan's initial maturity date is May 2023. However, in recent conversations, the sponsor indicated it does not want to continue the business plan. The loan remains current, and KREF is evaluating alternatives to maximize value including a potential sale of the loan or properties. Second, the Minneapolis loan is secured by a 1.1 million square foot, two-building Class A property. Our loan supported the refinance of remaining CapEx and subsequent lease-up of the property from an occupancy of 62% at closing to an occupancy rate of 88% today. NOI from the property generates a current debt yield of over 8%, fully covering the debt service on our loan. However, the loan has an upcoming final maturity date in December 2022, and the sponsor has indicated an inability to refinance the loan given current market conditions. We are continuing to dialog with the sponsor and are considering numerous options. Regarding the broader portfolio, 89% of our loan portfolio remains risk-rated 3 or better. We collected 100% of scheduled interest payments across the entire portfolio in Q3 and through the first payment period in Q4. In summary, KREF finished the quarter with a $7.7 billion total funded portfolio which has grown by approximately 33% year over year. We originated two senior loans in Q3 for a total of $458 million and have over $400 million in loans under exclusivity. This quarter and subsequent to quarter end, we sourced and closed two new non-mark-to-market financing facilities and completed a second upsize on one of our existing non-mark-to-market facilities to $1 billion. Finally, we repurchased approximately 600,000 shares of common stock at a weighted average price per share of $17.42 in Q3, for a total of over $10 million. Over the last two reported quarters and subsequent to quarter-end, we have been opportunistic in utilizing our share repurchase program, with year-to-date purchases of 2.1 million shares for a total of $36 million. Our record liquidity puts us in a strong position to efficiently manage in this current environment, and to further capitalize on the market opportunities ahead of us. Thank you for joining us today. Now, we're happy to take your questions.

Thank you. We will now begin our question-and-answer session. The first question will be from Jade Rahmani with KBW. Please go ahead. Jade, your line is open. Perhaps your line is muted.

Yes.

Thank you. We can hear you now.

Great, thank you very much. There's definitely indications that credit is turning. Do you agree with that? How do you expect the cycle to play out? Specifically, I am interested in understanding, with rates this high and credit spreads extremely wide; many borrowers are going to have difficulty refinancing at today's levels. Modifications become very important, which means capital, wherewithal. You noted the $900 million of liquidity, working with lenders. I know KREF has a high percentage of non-mark-to-market financing, and assessing borrower commitment to the property. So, as you approach credit overall in asset management, is that going to be your primary focus? Can you also touch on upcoming loan maturities, which I believe you spell out in the slides. Is that all-encompassing about what you expect for the remaining part of this year and next year?

Great, Jade, thanks for the question. It's Matt; I can take it, and, Patrick, if you want to jump in on the second point around the repayment profile. First of all, just regarding the credit dynamics, I think it's a little bit market and property-type specific. If you look at most of our portfolio, it's in growth markets, and, obviously, multifamily being the largest component of that. We have positions within industrial and life science as well, and we're still seeing strong growth there, strong tenant demand. I'm not sure that will be a big part of a default cycle. I agree with your point that there could be modification discussions over time, but we're really not seeing anything from a property-fundamental or cash flow perspective that would suggest issues in those markets. Office is different, however, and as we highlighted within our prepared remarks, the lack of liquidity there and the uncertainty in that sector is very high. As it relates to workout strategies, it's going to be fact-dependent. If there is a sponsor operating a property well and is willing to invest more capital, we would be open-minded to modifications and extensions to maximize value. If the opposite is true on either front, we will have to create our own liquidity for that potential position. We've got a range of options available to us as we go through this credit cycle, but it will be very fact-dependent on individual property circumstances.

Jade, I'll take the second part of that question regarding the maturities that are coming up. We have a page in our supplement, page 21, which details the loan maturities. As you asked, what we're reflecting here are the final maturity. In 2022, you can see that $194 million is the Minneapolis loan which we talked about on the opening remarks. A lot of the maturities are backdated; much of the portfolio was originated over the last couple of years. As we look out into 2023 and 2024, it's relatively light in terms of upcoming final maturities.

Thank you. I'll get back in the queue.

Thank you.

Thank you. The next question will be from Stephen Laws from Raymond James. Please go ahead.

Hi, good morning. Maybe to follow up on the office sector, can you talk about how those are financed? Are any in CLOs? Are they all on credit facilities? How are your discussions with those counterparties going regarding credit market, advance rates, and things of that nature?

Sure. Good morning, Stephen. It's Patrick; I'll take that question. These loans are financed across a variety of our facilities. As we have discussed repeatedly, we're very focused on a diversified financing structure. Our office loans and our portfolio, in general, are really diversified in where these loans reside. Some of the office sector is financed in CLOs, and some in our non-mark-to-market facilities. We also have some assets that are unencumbered right now, so we have a lot of flexibility there. In terms of discussions, not a lot to date. Looking at the performance, as we've noted, 100% of the interest payments have been collected, so the loans are performing. As we get closer to these maturity dates, I expect increased conversations. Given the liquidity we discussed, we feel well positioned to manage through those discussions regardless of what the outcome is.

Thanks, Patrick. Matt, I want to shift over to a comment because there are a couple of things going on: the benefits of higher rates and, obviously, any repayment; some CLOs can be replaced at wider accretive spreads or, on the flipside, concerns over portfolio performance going forward. When you think about your statement of a 100 basis point increase resulting in $0.21 annualized NII, what type of portfolio deterioration does it take to offset that? It's a bit oversimplified, but if those office assets are at 11% and you take out 11% of interest income, that's still not $0.21 per share. Curious how you think about those opposing forces as you look over portfolio performance.

Yes, Stephen, happy to cover that. We think that the portfolio performance should be pretty resilient here regarding convexity to increasing interest rates. We have modeled a number of scenarios, especially as it relates to your concerns about some of these 5-rated loans. We still believe that the coverage versus the dividend will remain strong, even when factoring in existing watch list assets for those loans. It is a good market right now to be investing. You are correct in noticing that we need to monitor existing portfolio health closely. However, we think that majority of risk will be concentrated in the office sector, which is a smaller component of our overall portfolio. Many of the remaining assets are in growth markets; we feel good about them despite the overall office market challenges. It's worth mentioning we received a recent repayment on an office loan, indicating liquidity remains for the right assets in the right markets.

Thanks, Matt. In our final question, you mentioned attractive new investments. I know Patrick mentioned mid-3s leverage going forward, which is part of the equation. How do you balance those attractive returns on new investments versus the stock buyback, which you've been pretty active with this year?

Yes, that's a fair question, and I think you have seen us do both recently. It’s not just one or the other; both are attractive from a fiduciary and shareholder perspective. We think it's right to buy back shares when they appear attractive. Another consideration is liquidity overall in this market, which takes precedence but when we have excess liquidity, we're evaluating the threshold between making new loans and buying back stock. From existing financing facilities, if we have open spots in the CRE CLOs, those are very attractive opportunities to generate accretive returns. So, liquidity and financing play crucial roles in whether we buy back stock or make a loan.

Appreciate the comments, Matt. Thank you.

The next question is from Donald Fandetti from Wells Fargo, please go ahead.

Good morning. This is Steve on for Don. Can you talk about your expectations for multifamily performance going forward with rates going up and the macro softening? Where and what property types are you still seeing attractive lending opportunities, if any? Thank you.

Sure. To start, on the multifamily side, we are still seeing very strong performance across the board in terms of high occupancies, good leasing environments, and strong rental growth. The growth has come off a little bit from the peak; we're seeing high single-digit rent growth in some of these markets. The values are adjusting as all real estate values are to the new cost of capital. So, in these growth markets, values are down about 10% to 15%. Regarding where we focus lending, it hasn't shifted much over the last few years. Our focus remains on these growth areas in property types such as multifamily, industrial, and life science, as we believe they have strong tenant demand. Given the competitive landscape, we are creating lower-leverage loans with higher returns and more structure.

Thank you. The next question will come from Steve Delaney from JMP Securities. Please go ahead.

Good morning, everyone. Thanks for the question. Your $81 million CECL reserve addition in the quarter, can you comment on any part of that that was specific to any of your rated loans, or should we view at all as just general unallocated reserves? Thanks.

Hi, Steve, it's Kendra. Thanks for the question. Taking a step back to talk about how we create the CECL reserve, we take a very conservative approach. The CECL reserve is evaluated and adjusted each quarter and considered on a loan-by-loan basis where individual facts are taken into account to estimate possible losses. Most loans are calculated using historical loss rates, third-party models, and macro scenarios. While we view our reserves holistically in relation to the entire portfolio, Patrick mentioned earlier about a couple of the 5-rated loans. We would prefer not to disclose more on the build currently to protect our commercial interests.

Totally understand that, not to show your hand obviously to when you're negotiating with a sponsor or borrower. That makes sense, thank you for that, Kendra. On page three of the deck, you say that 100% of interest was collected in the third quarter. Does that include 5-rated loans where there still may be an interest reserve on the loan that has not yet been exhausted?

Steve, it's Patrick. I'll take that question. Yes, so 100% was collected in the third quarter. We've obviously had the October payments, we've collected 100% there regardless of whether the loan is risk-rated one, two, three, four, or five. In some cases, we also have interest reserves on all of these loans, so we have a structure that allows us to cover any potential interest shortfalls.

That does, thank you. And lastly on the new life science focus, with the two new loans being construction loans, do you normally find significant pre-leasing commitments in place for specialized properties? Or should we view these as more speculative buildings?

I can jump in on that one. On the construction lending we have done, there's a range. Some are for lease-up, while others have existing tenants. These two are lease-up strategies located in strong markets, catering to the most institutional and largest companies in the life science segment.

The next question is from Eric Hagen with BTIG. Please go ahead.

Hey, thanks. Good morning, guys. First one is can you just discuss how you stress loans during the underwriting process for both NOI growth, and a takeout through refinance or an asset sale? What variables do you use? Especially with respect to interest rate risk management for the sponsor?

Eric, it's Matt. I can take that. Our loans obviously have interest rate caps in place, which is crucial. So, for our current underwriting, we emphasize the current rent and occupancy environment and aim to stabilize at a debt yield that's well above current cap rates. Our base case doesn't give credit for future rent growth, but we also stress cap rates along with declines in both rent and occupancy, considering various market factors. We've seen the market decrease leverage materially based on anticipated declines in values. This year, there's been a debt-led decline in market leverage availability.

Got it. That's helpful detail. At a high level, if investors have the option to concentrate on stabilized assets versus construction assets, where do you think they find better relative value, especially factoring in liquidity and funding for one versus the other?

We certainly put a higher premium on construction lending due to the nature of future funding. There is incremental risk associated with constructing an asset versus something in place. However, construction remains a small piece of our portfolio. Most of our lending focuses on funded, built assets as more accretive and stable. We also consider development opportunities in strong markets with reputable sponsors, as we've seen this quarter with two loans. However, these also come with premium risks and generally remain a smaller segment of our overall portfolio.

That's helpful. Thank you guys very much.

Thank you. The next question is from Kaili Wang from Citi. Please go ahead.

Thank you. Most of my questions have been asked and answered. But in terms of share repurchases, how should we think about the pace of that going forward?

It's Matt, I can jump in. Thank you for the question. What we've seen over our history is that we've been a market leader in terms of buying back shares. You saw it at the outset of COVID. We highlighted what we've done over the course of this year. As I mentioned, we continue to evaluate the relative value of share buybacks compared to making a loan. Sometimes, the loan equation is going to factor in our available financing and the returns we can generate from that. The biggest piece right now is overall liquidity, ensuring that we maintain a lower leverage point to be defensive in this volatile market and be prepared for future opportunities. We'll continue weighing these, but our track record reflects how we view share buybacks.

And the next question is a follow-up from Jade Rahmani with KBW. Please go ahead.

Thank you very much. On the Minneapolis office, it was risk-rated two last quarter and now it's risk-rated five. What changed? Was it the interest rate shock and the timing of the upcoming maturity, and what does your dialogue with the borrower currently suggest?

Thanks, Jade. It's Patrick. Timing is a big factor here. Each loan has a different approach. This asset was under contract in spring for a good premium relative to our debt, but that contract fell through over the summer. We now face a maturity date in December, which reflects in the risk rating. All options are on the table, including extending the loan. As we approach this maturity date, we will explore how to maximize shareholder value. Our dialogue with the sponsor will continue as we evaluate options and potential financing.

Thank you very much. You mentioned, Matt, that multi-family values in growth markets you believe are down 10% to 15%. What about the office sector? There is a bifurcation in the office space, but could you generalize? Also, what’s the case for commercial real estate prices overall?

The challenge in the office market is uncertainty. There’s not much liquidity outside high-class A or trophy assets. That’s the challenge we’re discussing with the Minneapolis asset. It’s hard to predict exactly where the office market stands. Given that growth markets are down 15%, it's reasonable to assume the office is down even more due to that uncertainty. The entire real estate market is adjusting to the new interest rate environment, though it's tough to speculate on the overall U.S. real estate value decline.

Some other questions we have all I believe gotten in the space in general. But where does margin call risk rank in terms of issues you are managing?

For us, it's not a significant concern. The majority of our portfolio is financed on a non-mark-to-market basis. We have significant liquidity, and we have not encountered margin calls during this cycle. As the market remains volatile, that risk could arise, but due to our strategic financing method, it isn't a current worry.

In terms of access to capital, clearly some positive initiatives or additions in the quarter with new asset-specific financing facilities, where do things stand in terms of talking to non-U.S. banks? Are they interested in gaining exposure to dollar-denominated U.S.-based assets? Could this area enhance our financing opportunities?

Go ahead, Patrick.

I will just say there are several different paths I think that we've got in this market. One area of potential growth is in non-U.S. institutions. Looking at where we have seen some growth in our financing capacity, that sector is contributing. It's not the only area, but it remains a hopeful opportunity for support in this market.

Thanks. Matt, do you have anything to add?

No, I think that's well said.

Great, thank you for taking the questions.

Thanks, Jade.

Great. Thanks, Operator, and thanks everyone for joining us today. Please reach out to me or the team here if you have any questions. Take care, everyone.

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