KKR Real Estate Finance Trust Inc. Q4 FY2022 Earnings Call

Good morning and welcome to the KKR Real Estate Finance Trust Inc. Fourth Quarter 2022 Financial Results Conference Call. All participants will be in 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.

Great. Thanks, operator, and welcome to the KKR Real Estate Finance Trust earnings call for the fourth 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 fourth quarter of 2022, we reported GAAP net income of $14.6 million, or $0.21 per diluted share, including a CECL provision of $21.2 million, or $0.31 per diluted share. Distributable earnings this quarter were $12.4 million, or $0.18 per share, including a write-off of $25 million, or $0.36 per share. Distributable earnings prior to realized losses were $0.54 per share relative to our Q4 $0.43 per share dividend, driven largely by the higher rate environment. Book value per share as of December 31, 2022 was $18, a decline of 1.5% quarter-over-quarter. Our CECL allowance decreased to $1.61 per share from $1.66 per share last quarter. Finally, in early December, we paid a cash dividend of $0.43 per common share with respect to the fourth quarter. Based on yesterday's closing price, the dividend reflects an annualized yield of 10.9%. With that, I would now like to turn the call over to Matt.

Good morning, and thank you for joining us today. Before turning to the current market and company results, I'd like to reflect on KREF's achievements during 2022. Despite a very challenging environment, we made significant progress enhancing our liquidity and diversifying our already best-in-class non mark-to-market liabilities. In 2022, we optimized and diversified our financing sources, and as a result, we sit on record levels of liquidity. Last year, we added $2.5 billion of non mark-to-market liabilities. Notably, we increased the borrowing capacity on KREF's corporate revolver by $275 million to $610 million and extended the maturity date through March 2027. This revolver is a key contributor to our nearly $1 billion in liquidity as of year-end. Seventy-seven percent of our secured financing as of year-end was completely non mark-to-market, and the remaining 23% is only mark-to-credit. In addition, we have $1.9 billion of CRE-CLO liabilities that are priced at attractive spreads and still in their reinvestment periods. In 2022, we grew our permanent equity base by 15% to $1.6 billion. We raised approximately $150 million of preferred equity at a 6.5% fixed-for-life coupon. We completed two public offerings of common stock, resulting in net primary proceeds of $188 million. KKR reached its target long-term hold position of 10 million shares, representing 14% of our shares outstanding, resulting in market-leading alignment between KKR and KREF. Equally as important was our disciplined approach to buying back shares when KREF traded below book value. In 2022, we repurchased 2.1 million shares for nearly $36 million. Since our May 2017 IPO, KREF has repurchased nearly $100 million of stock. I cannot overstate the impact of our partnership with our manager, KKR, and the strength of our real estate platform. KKR's integrated real estate business provides us with a robust view of the current operating environment, which has become more dynamic over the past few quarters as the Federal Reserve has embarked on a virtually unprecedented pace of interest rate increases. This broader real estate platform collectively manages over $64 billion of AUM and has grown by approximately 60% since the end of 2021. For example, KKR's real estate private equity team owns or manages over 90 million square feet of industrial assets and over 30,000 multifamily units globally. We are able to draw on real-time data and market intelligence from this property portfolio, which informs our investment decisions as a lender. The KKR real estate credit business is substantial in its own right, with $30 billion of assets under management and a dedicated team of 66 at year-end 2022, with nine senior investors responsible for over $10 billion in originations. As a reminder, KREF is KKR's flagship senior transitional CRE lending strategy and holds a first priority position within the allocation waterfall. This team originated $2.7 billion on behalf of KREF in 2022 across 25 loans, focusing our efforts on the growth property types, with nearly 70% secured by multifamily and industrial properties, and another 22% secured by life science properties. Our focus on lending to institutional sponsors on high-quality real estate and growth sectors and markets has positioned us well to navigate the current environment. Our largest property type is multifamily, which represents approximately 45% of the overall portfolio. We continue to see strong performance across that segment, with median same-store rental rates up 12% in the portfolio from the fourth quarter of 2021 to the first fourth quarter of 2022. That said, and as we discussed last quarter, the office sector remains challenged with little liquidity across both debt and equity. Our underweight in office will benefit KREF on a relative basis, and we are diligently working through our watch list office loans. Our first preference is to work with our existing sponsors. However, many properties will require additional capital, and sponsors will need to demonstrate commitment to the asset with additional equity. We are not in the option business, and our mindset is to deal with any issues now, and not to kick the can down the road with a sponsor who is not economically incentivized to meet current market rates. Fortunately, we have many tools at our disposal to optimize these outcomes, including taking title and operating assets until liquidity returns. We're also in a position to be proactive with our borrowers and work toward faster resolutions because we have high levels of liquidity at the corporate level. Turning to earnings. The high interest rate environment continues to be a tailwind for our distributable earnings. In 2023, we expect the portfolio to turn over modestly, and we will continue to match originations with repayments. We expect repayments for 2023 to be approximately $1 billion, weighted to the back half of the year. As we navigate this New Year, we’re very well-positioned with a strong portfolio, best-in-class liabilities, and record levels of liquidity. Lastly, I want to take a moment to thank Todd Fisher, who resigned from the KREF Board of Directors earlier this month to accept a position with the United States Department of Commerce. Mr. Fisher has been an integral part of our team since KREF's inception. We thank him for his thoughtful guidance in steering the company. We wish him well in his future endeavors. 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. In 2022, with the continued help of our partners in KKR Capital Markets, we added $2.5 billion in non mark-to-market financing. In the public capital markets, we closed a $1 billion managed multifamily CLO earlier in the year, providing KREF with $848 million of non mark-to-market and non-recourse financing during the two-year reinvestment period. In the private markets, we closed on a term lending agreement totaling $350 million with an option to increase the facility to $500 million, and we entered into three new asset-specific financing facilities, totaling nearly $500 million. We also increased the borrowing capacity of an existing $500 million term lending agreement to $1 billion. Finally, we increased our corporate revolver by $275 million to $610 million and extended the maturity date through March 2027. Of the $2.5 billion in total capacity added this year, two-thirds are truly bespoke liabilities. The resiliency of our financing structure, coupled with our independence from the public capital markets, is a true differentiator. It buffers KREF on the liability side, during times of capital markets volatility. KREF is well-capitalized today, continuing to preserve flexibility in today's market environment. Our debt-to-equity ratio was two times, and our total leverage ratio was 3.8 times as of quarter-end. Our approach to managing the balance sheet allows us to start 2023 with a record level of liquidity in excess of $950 million, including our $610 million undrawn corporate revolver, and $240 million of cash. Additionally, at quarter end, KREF had $180 million in unencumbered senior loans on the balance sheet. We're maintaining our defensive posture with a focus on managing liquidity. This quarter, we recorded a $4 million net decrease in our CECL reserve of $115 million to $111 million or 147 basis points based on the funded loan portfolio. Similar to our commentary in Q3, nearly half of our total CECL reserve remains held within our five-rated loans. Additionally, as we noted last quarter, the CECL reserve is unrealized and non-cash. We would recognize a loss through our cash metric of distributable earnings if such amounts are deemed non-recoverable, as we did this quarter. Turning to the watch list, in December, we finalized the plan to modify a $161 million senior office loan, previously risk-rated 4 located in Philadelphia. As part of the modification, KREF agreed to subordinate $25 million of our senior loan in the form of a junior mezzanine loan in return for a $25 million principal repayment from the sponsor. The principal repayment is structured as a new senior mezzanine loan and reduces KREF's mortgage exposure to $111 million. At year-end, the loan was risk-rated 5. However, following the execution of the modification in January, the new senior loan was upgraded to a risk rating of three. In addition to the $25 million pay down, the sponsor committed to fund an additional $16.5 million for future capital expenditures and leasing costs, which will bring the total senior mezzanine loan balance to $41.5 million fully funded. The subordinated note is structured as a junior mezzanine loan and does have priority of cash flow once the senior mortgage and senior mezzanine loans are fully repaid with interest. KREF wrote off $25 million of the loan balance in Q4. Regarding our other two risk-rated 5 loans, there are sponsored lead sale processes in progress, and we are maintaining an active dialogue with these sponsors. In the Minneapolis loan, we executed a short-term extension to facilitate the sale process. And for the other Philadelphia loan, we have an initial maturity date in May of this year. With regard to the broader portfolio, 88% of our loan portfolio remains risk-rated 3, and we collected 100% of scheduled interest payments across the portfolio in Q4 and through the first payment date in 2023. A few final comments. KREF finished 2022 strong with a $7.9 billion total funded portfolio representing a 17% year-over-year increase. We originated three senior loans in Q4 for a total of $370 million and sourced closed $125 million in asset-specific financing. Finally, we repurchased approximately 500,000 shares of common stock in Q4 at a weighted average price per share of $16.41, totaling over $7.4 million. Over the last three quarters, we've been opportunistic in utilizing our share repurchase program, with 2.1 million shares repurchased in 2022 for a total of $36 million. Additionally, this month, the board reauthorized a $100 million buyback program. Thank you for joining us today, and now we're happy to take your questions.

And our first question will come from Don Fandetti of Wells Fargo. Please go ahead.

Hi, good morning. Obviously, office continues to be a pressure point. Can you talk a little bit about how your borrowers are handling the higher rate environment? Are you making modifications? And just talk a little bit about your expectations. I would assume that there'll be more reserve building on your office portfolio as we go forward through 2023?

Sure, Don, it's Matt. Thank you for the question today, and I appreciate you joining the call. I'd say specifically, let's start with the interest rate environment right now, which is certainly putting a lot of pressure on the overall system. However, borrowers do have interest rate caps in place. And so, they're not fully exposed to current SOFR or current LIBOR if we haven't converted it over yet. As those interest rate caps expire, typically at the initial maturity date of the loan, they are required to renew those interest rate caps and buy a new one. That's really when the conversations take place around potential modifications on the loan; it's another opportunity for us to evaluate credit and understand where we are and add any other structural features that we want. We've been working with our sponsors in terms of giving them some flexibility on their interest rate caps. For instance, if an interest rate cap requires a two-year term or a very low strike, we accommodate them to either a shorter duration or a little bit higher strike in return for typically cash reserves that we would hold for future interest rate cap purchases, etc. So yes, we want to work with them and help alleviate the pressure points related to that, but it's typically in return for some type of other consideration within the loan document. As it relates to further buildup on office, in terms of our reserves, we go through the portfolio every quarter. Where we stand now, we feel comfortable with the reserves. It is a very robust process. I think we're keeping our eyes wide open. You'll see us being very transparent and proactive as it relates to not only increasing reserves but also modifying loans and trying to ensure we create the right basis for us and for sponsors so they can lease in what's a challenging operating market for office. So, we feel comfortable right now with where we stand on the reserves, and we'll just have to see what the future brings in terms of how we're positioned elsewhere.

Thanks.

Our next question comes from Rick Shane of JPMorgan. Please go ahead.

Thanks, everybody, and I appreciate you taking my question this morning. Look, one of the few places where GAAP and tax diverge is related to realized losses. So, to the extent you did realize a GAAP loss of $25 million, I'm curious if you believe that it's met the threshold from an IRS or tax perspective as well. And then, if you could talk specifically about, because it occurred in the fourth quarter, but perhaps the tax loss might be realized in 2023. How we should think about the timing and how that falls?

Sure. Thank you, Rick, appreciate you joining and appreciate the question. You asked about the write-off that we incurred in Q4, and that $25 million write-off will be a taxable event in the year the modification closed, which was 2023. Maybe pulling the thread on this a little bit, the sum of our quarterly dividends paid in 2022 plus part of the dividend that was paid in January 2023. The throwback dividend concept is a practice that’s allowed under the REIT rules and that we've used in the past means that we are fully distributed for 2022. So, there is no special dividend that would be required.

Got it. No excise tax or anything that we need to think about in that regard?

That's right. We met all of those thresholds. That's correct.

Terrific. Thank you very much.

Thank you.

Our next question comes from Stephen Laws of Raymond James. Please go ahead.

Hi, good morning. Patrick, I guess, I'll start with pointing this to you since you mentioned it in your comments. But I think half the reserves are related to the 5-rated loans. As we think about that and pair it with Matt's comments that are focusing on resolutions quickly and not kicking the can down the road, how do we think about those moving from specific losses to realized losses running through distributable earnings over the course of this year?

Stephen, thanks for the question. If you look at our reserves, as we said, about half of the reserves are attributed to the 5-rated loans. For the asset, where we had the write-down in the fourth quarter, we realized the write-down at about 16% against a balance. Coincidentally, the reserve that's held against those 5-rated loans is pretty close to that number. We're obviously working through each of these loans individually, as all the fours and fives that are on there will have potentially different levels of loss content. Not every 4-rated loan is a loan where we think there's a high degree of loss; some of the 4-rated loans are on there as a reflection of the fact that we think there's a near-term catalyst or event that may lead to a modification. So hopefully that addresses what you were asking.

Yes. I guess, kind of to take half of the one where we were 111. So, if you're looking at $55 million, we see all of that runs to a loss, assuming your reserve is at the appropriate level for the assets resolved or monetized, but just trying to think about the timing of when that's going to hit. Is that a this-year event? Is it early next year? How do we think about the timing of those monetization realizations?

Yes, sure. I think the timing is difficult to forecast here. Clearly, with those 5-rated loans that we talked about, there are processes in place to get to some form of liquidation event. So, it’s not unreasonable to think that we could see some realization over the course of this year. I think the bigger question probably relates to the quantum there. We feel good about where we're reserved, but clearly in this market, the realized amounts could come in greater or less than what we've set aside.

Yep. Thanks, Patrick. And moving to the financing side on these loans, can you talk about how the watch list loans are financed, and if that is financing exposed to credit markets? How are those discussions going with counterparties as you work through these watch list loans?

Sure. There's a little bit of a disconnect between what's on a watch list and whether the loan is performing. As we've indicated, we collected 100% of our interest payments through last year and the first payment date of this year. The real driver, especially on these non mark-to-market facilities, is whether the loan is current. In fact, all of these loans are current. So there isn't really much concern in the immediate term, as it relates to those loans. Obviously, as we get to maturity dates or need further modifications or restructuring, that's when we're going to have more in-depth conversations with our lenders. I'd say those conversations have been constructive. And to date, as we've worked through some of the loans, the asset that we had a write-off in the fourth quarter that was not on a financing facility was unlevered. But now with the modification, that loan is one that we can finance on any number of facilities. The conversations have been constructive, and we have an opportunity to work through and get runway where needed.

Great. Appreciate the comments this morning, Patrick.

Thank you, Stephen.

Our next question comes from Jade Rahmani of KBW. Please go ahead.

Thank you very much. I wanted to ask, in terms of your quarterly interest income, do you know what percentage of that is funded out of interest reserves that are structured upfront as part of the loans?

Hey, Jade, this is Matt. I can jump in there. I don't have that number right in front of me now. It's not abnormal for us to have reserves or recourse obligations to new guarantees to fund interest payments, just given the nature of the business plan and lease-up, etc., but don't have the exact number in front of me.

Okay. But is that an issue in terms of any shortfall in performance and pressure from elevated interest rates, the exhausting of those reserves in coming quarters?

I mean, what's it comes back down to value at the end of the day. Most of our portfolio is in these growth sectors, and the value there has held up well, with the fundamentals really strong. I kind of put this in the same bucket as interest rate cap discussions. As those expire, there's a lot of value behind these loans, and the sponsors re-up and come out of pocket to buy the next interest rate cap. So, many of our reserves are set to accommodate for interest at the cap, etc. But to the extent they're not, I wouldn't expect a lot of pressure there. I would expect the sponsors to re-up on the reserve.

Thank you very much. On the multifamily credit outlook, it was somewhat surprising to see the downgrade on the West Hollywood asset. I was wondering if you could talk to your overall expectations for that sector? It's definitely been resilient in past cycles. However, the early 90s did see credit issues. And CMBS throughout time has always had credit issues in multifamily. This time around, we do have a record level of units under construction, disproportionately concentrated in the growth markets. And a lot of deals done at very low cap rates, which would have pressure from valuation as well as interest rate caps. So what would be your outlook in terms of multifamily credit performance?

Yes. We still have a very favorable outlook on multifamily credit performance. Clearly, values have come down a little bit too, and cap rates have increased just to accommodate the higher cost of capital and the current interest rate environment. On the occupancy side, the properties or markets are still operating at basically all-time highs. We're still seeing pretty favorable rent growth, although it’s come down quite a bit. As we reported, in our KREF portfolio, rents were up on a same-store sales basis, 12% year-over-year from the fourth quarter of 2021 to the fourth quarter of 2022. I expect that to continue to taper down; my guess is across a broader set of assets, that’s probably in the high single digits today, which I still think is very healthy. The Fed's activity is obviously having some impact on that, which is probably a net positive for the market. In terms of supply, I agree there is a wave coming out right now, which could impact some of these local growth markets. But at the end of the day, all these markets are under-housed. This is really just a short-term phenomenon in terms of the market digesting those new units. Keep in mind, there hasn't been a lot of new construction financing available in the market over the past six months or so, certainly not readily available today. You might see a little bit of a blip as the market goes through that, and then, it should be a pretty favorable setup after that, with the new supply tapering off. Overall, I would say we remain very constructive on that market and haven't seen any material signs of deterioration.

Thank you very much.

Our next question comes from Eric Hagen of BTIG. Please go ahead.

Hey, thanks. Good morning. I'm curious how you think your appetite for risk changes as a result of raising your reserve. Should one expect the parameters for your target assets to change? And is there a threshold for further reserve where it does begin to change your risk parameters more significantly?

Eric, you're speaking about new loans in terms of how we're evaluating the current market, etc.

Exactly. Yep.

Yes, let's start there. Number one, it’s a very lender-friendly market right now. You've got large participants completely on the sidelines. Commercial banks are still not actively lending in the market. Your loan-to-values have come down a fair amount, obviously, and we are in that equation down with the current interest rate market. So, we like the market right now; it’s very attractive. The vast majority of our lending activity was in multifamily and industrial sectors, which we still believe have a strong fundamental backdrop. I don't think that really what we're looking at in terms of reserves or other factors are significantly impacting how we're thinking about making new loans. Some does come back to liquidity. As you saw in our report, we are at pretty high levels of liquidity right now. I think that's more a function of the market uncertainty and volatility, ensuring we have plenty of excess liquidity to deal with any issues that may arise. It’s less about reserves; one of the reasons we've been proactive and working on some of these loans was clearly evident in the modifications we did this past quarter. Once we get through this, there should be a great opportunity to lend on the other side of that. It’s probably less about reserves and more about just monitoring liquidity and addressing a few of these loans we have rated 5. Once we get through that, I think that will change some of our posture regarding current market opportunities.

That's really helpful. Maybe you can share some of the things you see from your seat at KKR more broadly about the flows of capital into commercial real estate, how much capital you see getting allocated to the sector this year, and who you see being the incremental buyer in the market amid this layer of uncertainty we're all talking about? Thanks.

Sure. Stepping away from KREF for a second and just talking about what we're seeing broadly in capital flows, I would say that the start in the real estate credit space, there is a pretty strong consensus view globally that credit is very attractive today. Within that segment, real estate credit is also viewed as very attractive. While a lot of allocators in the market are experiencing a denominator effect due to current equity market conditions, to the extent that the overall market might be shrinking, I think you might want to consider that the real estate credit component is actually growing. So we're gaining market share, if you will. We're certainly seeing that on the fundraising side with more allocators favoring real estate credit. That presents a good opportunity. On the real estate equity side, markets are challenging values and understanding where they stand, thinking about their portfolios. Still, I expect opportunistic funds to have success in raising capital, as there is ample dry powder available today, with almost record levels of capital ready to invest in real estate. The fundamental setup across many of these property types and markets remains solid. You’ll continue to see capital being raised on both the opportunistic side and the equity side. Overall, while everyone’s dealing with some headwinds from the denominator effect, I'm still seeing very good flows across the real estate spectrum.

That's really helpful. Thank you.

Our next question is a follow-up from Jade Rahmani of KBW. Please go ahead.

Thank you very much. You mentioned the $1 billion repayments this year. Do you know the dollar amount of loans scheduled for initial maturity that will have to meet some kind of extension test? I know you talked about how you're not giving away anything for free, so it sounds like you're going to be pretty strict in those discussions.

Yes, Jade, I can discuss it, and I'll turn it over to Patrick to give you the exact number. But a lot of the portfolio was originated post-COVID, so it is a smaller dollar amount. We'll give you the initial maturity here. I agree, however, we want to collaborate with our sponsors and be reasonable. Just remember that all those initial maturities or most of them will have some form of test to enter extension periods. Those tests can usually be met, and in cases where they're not met, that provides another opportunity to discuss and improve our overall credit. With that, I'll turn it over to Patrick. He could add any additional comments and provide the numbers.

Jade, sure. Happy to elaborate. So in the supplement, we show our fully extended terms. This year, about 6% of the portfolio is scheduled to have a final maturity date in terms of the initial maturity date. Inclusive of those numbers grows to about 21% of the total portfolio. So about $1.7 billion in total.

Thanks very much. The West Hollywood multifamily deal. Sorry, I didn't hear before. But did you provide any color on that deal? And if not, could you talk to just some overall statistics or give some sense of what characterizes it? I see that the average unit value is something like $2 million per unit, and with your cap rate assumptions, you're determining rents north of $15,000 a month. So, any colors you can give there, and why that deal was downgraded to risk-rated 4?

Yes, sure. I can give you a bit of color. You are correct; it’s a very high-end luxury multifamily property built primarily for condos. It’s positioned at the top of the market and in a great location in West LA. We downgraded it due to modification discussions surrounding interest rate caps and ensuring we reach a favorable position as those discussions are ongoing. It goes back to value as well. We are confident in our overall asset base and its value. The downgrade was primarily due to the discussions regarding modifications on interest rate caps.

Thanks. I have one more. If there are any other questions in the queue, I just wanted to ask it, as I've received some investor inquiries on this.

Sure, go ahead, Jade.

Just on the CMBS exposure, which is a joint venture. What's the risk of any write-down there? And I believe those positions are B pieces, so there would be special servicing rights? Is that really just a marks model calculation? What would drive any value designation there that we can see?

Got it. Yes. So that's an investment in a fund that owns 2017 and 2018 vintage conduit B-pieces. The marking process is similar to everything we do at KKR; it's a third-party service provider that handles the marking. We don’t manage that internally using a model. The main factors impacting that market are risk premium increases and fundamental factors related to defaults. Across our overall CMBS portfolio, I would say we continue to see strong performance, especially on the conduit side, where these borrowers have locked in 3.5% fixed interest rates for 10 years, with going-in coverage typically over 2.5 to 3 times coverage on those lower interest rates. They’ll benefit from that interest rate for quite some time. We continue to see strong performance across that portfolio with minimal delinquencies.

Thanks very much.

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, operator. Thanks everyone for joining today, and please follow up with me or the team here if you have any questions. Take care.

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