KKR Real Estate Finance Trust Inc. Q3 FY2023 Earnings Call

Good morning, and welcome to the KKR Real Estate Finance Trust Incorporated Third Quarter 2023 Financial Results Conference Call. All participants will be in listen-only mode. 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 third quarter of 2023. 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’d 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 2023, we reported GAAP net income of $21.4 million or $0.31 per diluted share. Distributable earnings this quarter were $17.4 million or $0.25 per share, including a write-off of $15 million or $0.22 per share. Distributable earnings prior to realized losses were $0.47 per share relative to our Q3 $0.43 per share dividend. Book value per share as of September 30, 2023, was $16.29, a decline of less than 1% quarter-over-quarter. Our CECL allowance decreased to $3.21 per share from $3.30 per share last quarter. Finally, in mid-October, we paid a cash dividend of $0.43 per common share with respect to the third quarter. With that, I’d now like to turn the call over to Matt.

Thanks, Jack. Good morning and thank you for joining us today. The portfolio continues to benefit from the higher interest rate environment. KREF averaged run rate distributable earnings of $0.48 per quarter throughout 2023, excluding realized losses. KREF benefits from KKR’s large real estate team with access to real-time market data across our $64 billion equity and credit portfolio. In addition, KKR has a dedicated rated special servicer and asset management platform called K-Star. Started in 2022, K-Star has over 45 people and $40 billion of special servicing rights, which enhances our market connectivity, gives us real-time performance information and enhances our ability to offer differentiated high-quality service to our borrowers and to drive asset management outcomes. The rate complex continues to evolve with higher for longer now the predominant theory, and the 10-year treasury closing in on 5% for the first time since 2007. This recent increase will likely lead to further declines in real estate values and create more cautious market sentiment. Borrowers continue to feel pressure from higher carrying costs, including the need to purchase interest rate caps and near-term loan maturities. However, this is not a surprise for us. We have positioned KREF to manage this market environment with proactive asset management, market-leading levels of liquidity, and diverse, largely non-mark-to-market financing. With the assistance of KKR Capital Markets, we have built high levels of liquidity and ended the quarter with $716 million of availability, including $108 million of cash on hand and $500 million of corporate revolver capacity. 76% of our secured financing as of September 30th was fully non-mark-to-market with the remaining balance marked to credit only. We have succeeded in terming out our debt and we have no corporate debt or final facility maturities due until Q4 of 2025. The composition of KREF’s financing structure remains a true differentiator. We continue to proactively manage our current portfolio of $7.9 billion, which remained effectively flat quarter-over-quarter. We received repayments of $152 million in the quarter across four loans, the majority of which was related to office pay-downs. Consistent with what we have previously stated, we expect limited repayments for the remainder of 2023, although we do expect repayments to exceed future fundings through 2024. As we determine the run rate earnings potential of the business into 2024, the main drivers will be interest rates, portfolio performance, and the ability to unlock equity health in our risk-rated five assets. At quarter-end, multifamily remains our largest segment by property type. Our multifamily portfolio has performed well with weighted average rent increases of 4.1% year-over-year, weighted average occupancy of 91%, and median year built in the multifamily portfolio of 2015. Office assets represent 25% of KREF’s outstanding portfolio. And as mentioned last quarter, we feel that we have identified the potential office issues within our watch list and do not anticipate further negative ratings migrations to the watch list from the office sector. Furthermore, in the third quarter, we did not downgrade any loans across the portfolio while we amended the risk ratings of 2 of our office loans higher. We raised our Chicago loan that had been on the watch list to risk rating of 3 following a modification, another example of our proactive approach to asset management. We also upgraded our Oakland, California office loan to a risk rating of 2 as we received a large partial pay-down of approximately 68%. We expect full repayment of the Oakland office loan in mid-2024. With that, I’ll turn the call over to Patrick.

Thank you, Matt. Good morning everyone. I’ll begin with updates to our CECL allowance and watch list, followed by our efforts on the capital and liquidity front. This quarter, there was a $6 million decrease in our CECL allowance for a total of $222 million or 293 basis points on our loan principal balance. The decrease in our allowance was partially a result of a subordinated note write-off in connection with an office loan that we restructured. We continued to proactively manage the portfolio, and to that end, in September, KREF closed on a modification of $118 million senior loan backed by an office property located in Chicago, previously risk-rated 4. As a part of this modification, the sponsor contributed $18.5 million of new capital, including a $15 million principal pay-down of the senior loan. In connection with the principal reduction, we increased the loan term for an additional five years and agreed to subordinate $15 million to the prior loan balance to the new contributed capital, and subsequently wrote off the subordinated loan. Following the modification, we upgraded the reduced senior loan of $88 million to a risk rating of 3 as of quarter-end. Similar to last quarter, approximately two-thirds of our total CECL allowance is held against three 5-rated loans. We continue to focus on solutions to efficiently resolve watch list loans while seeking to maximize shareholder value. Whether the best path leads to a loan modification or taking title and managing the property, we have the tools at our disposal to maximize outcomes across a host of scenarios. With this in mind, I’ll provide a brief update on some of our watch list office loans. Regarding our Mountain View Office loan, we continue to consider next steps for the asset, which may include taking ownership as we work with the sponsor on a transition plan, including exploring a path with a JV partner. As a reminder, this property is a recently renovated, very high-quality Class A office campus located in a more challenged leasing market. While precise timing is uncertain, we would anticipate transition to a new structure to be completed within the next couple of quarters. Regarding our $156 million Philadelphia office loan, the previously discussed short sale process for the entire portfolio did not result in a sale of the asset this quarter, and so we provided the existing sponsor another short-term loan extension as we evaluate next steps. The loan is secured by a portfolio of four separate buildings totaling 711,000 square feet, including a 500-space parking garage, and we are exploring parallel paths of taking ownership of one or more of the properties while continuing to explore individual asset sales. We’ll provide further updates on this process next quarter. Additionally, subsequent to quarter-end, KREF finalized modification on a risk-rated 4, $176 million Washington DC loan, which included a $20 million partial pay-down, an additional year of term, and spread reduction. Following some positive leasing momentum, the property is currently 92% leased with a weighted average lease term of 12.8 years. As a result of the pay-down and recent leasing activity, we would anticipate a potential risk rating upgrade during the fourth quarter. On the other risk-rated 4 Washington DC office loan with a current balance of $169 million, the property is now currently 88% leased following strong leasing activity this year. The sponsor is currently pursuing a recapitalization. Away from the watch list, our risk-rated 3 or better office portfolio, which equates to just under half of the outstanding principal balance of the office segment continues to perform well and has attractive credit metrics. In aggregate, the eight properties representing these underlying risk-rated 3 or better office properties are 90% leased with a weighted average debt yield of 9.5% and a median of 8.2 years of weighted average lease term remaining. Consistent with the prior quarter, the average risk rating of the portfolio was 3.2 and 85% of our portfolio is risk-rated 3 or better. Our portfolio is 99% floating rate, and all of our floating rate assets and liabilities are benchmarked to SOFR. KREF has built a fortified liability structure with $8.9 billion of financing capacity and $2.7 billion of undrawn capacity. A portion of our non-mark-to-market capacity remains substantial at 76% and is diversified across two CRE CLOs and a number of matched term lending agreements and asset-specific financing structures, as well as our corporate revolver. We continue to optimize our two CRE CLOs, reinvesting over $400 million of proceeds year-to-date on attractive financing terms. Excluding matched term secured financing, there are no corporate debt or final facility maturities until late 2025. KREF is well capitalized with a debt-to-equity ratio of 2.3 times and a total look-through leverage of 4.1 times as of quarter-end. As of September 30th, KREF had $108 million of cash and $500 million of corporate revolver capacity available. Our best-in-class non-mark-to-market financing and high levels of liquidity, coupled with our deep relationships with both our financing partners and borrowers, position KREF strongly for this dynamic CRE credit and interest rate environment. Thank you for joining us today. Now, we’re happy to take your questions.

Today’s first question comes from Sarah Barcomb with BTIG. Please go ahead.

So, you commented in the prepared remarks that approximately two-thirds of that total CECL reserve is allocated to those three 5-rated office loans, pretty similar to last quarter. It looks like the reserve on those assets is still being triangulated with a cap rate of about 6.6% to 8.7% in the Q, whereas the implied cap rates in the equity markets for high-quality stabilized office REITs are north of 9% in some cases. So, I’m just curious as to what’s driving the reserves there, especially given that we haven’t yet seen a resolution or a buyer come in for those assets that we might have expected as part of these results. Thanks for any comment there.

Thanks, Sarah. It’s Matt. I appreciate the question and you joining us today. Yes. I mean, obviously, there are a number of assumptions that are going into that, one of which is cap. There are lease-up assumptions as well. And then we’re also looking at, when you think about some of these assets that are a little bit further down the road or have gone through some form of sales processes. We’re actually looking at where things are pricing in the market around us or specifically for these assets. So, when we look at those reserves, I think we still feel pretty good about the quantity of those reserves against those 5-rated loans when we factor in all those different inputs at this point in time.

And then, just another one for me. So, excluding that $15 million loss on the Chicago asset that you talked about, earnings and cash flows comfortably covered the dividend this quarter. So, with that in mind, are you thinking about a potential pivot to offense here just given liquidity is looking pretty good? And at what point do you go out into the market and maybe start to take a look at sourcing high coupon loans with any comment on sector interest there? And just given the equity markets are a bit tough right now, how are you thinking about sourcing capital? Are you comfortable with liquidity in place for offense versus defense? Is there any opportunity for KKR to come in for the REIT? Just curious on any comments there. Thank you.

I think there are a couple of questions embedded there. Let me try to answer those in totality. One, from just a liquidity perspective, which I think was towards the end of the questions, I think we feel really good about where we stand from a liquidity perspective. We addressed that in some of the prepared remarks on the call here. And we’re still at pretty close to our highest levels of liquidity. So, we’ll continue to maintain that. From an offensive versus defensive perspective, I still think we’re in maintain liquidity mode here. We want to understand what the market environment looks like. We want to see more velocity and repayments in our loan book. We want to see a return to normal across the broader real estate equity complex and the broader capital markets as well. We’re obviously still in a very dynamic rate environment. The geopolitical landscape is quite volatile right now. So, I’d say we’re still in let’s continue to maintain this high level of liquidity. As we start to get into 2024, could you see that pivot? I think that’s potential for sure. We are anticipating more repayments in 2024 in our portfolio. And so certainly if that starts to come to fruition and we start to see more velocity there, we would want to go out and redeploy that capital into the market. Away from KREF, as you well know, we’re actively lending across insurance capital, bank capital, as well as debt fund capital. So we’re actively pursuing the market. And it is a market where you just want to kind of keep it simple. So, we’re sticking to those on-theme property types that we all know, so multifamily and industrial and just try to take advantage of not only the volatility I just described, but there are clearly some capital sources out of the market, namely U.S. domicile banks. So, I think that to the extent we turned on KREF, we’d be pursuing some of those same types of themes into next year.

The next question comes from Stephen Laws with Raymond James. Please go ahead.

Patrick, I appreciate the comments on the loans. I may have missed it, but could you give us an update on the Minneapolis office and what the outlook is and options there?

Sure, Stephen. Good morning. So, we didn’t have any comments specifically on that asset, not too much to report from last quarter. As you know, we’ve done the modification. That asset on the new senior rate covers. We’ve got lease terms in place for some considerable duration. And so, that loan’s got term through 2025. So, no real update. We continue to actively work on that asset, particularly just around some of the leasing activity, but no further updates on the market.

Great. And can you talk a little bit about the restructuring for the modification process? I think if I’m looking at my notes correctly, maybe one received a short-term extension. I think it was three years. So, maybe on the restructuring on the new senior. Can you talk about the considerations that go into how much additional duration you’re willing to give? Is it certain property types, certain borrowers, certain business plans? Can you talk a little bit about how the modification and restructure discussions are going as you look at what six or seven loans left to address?

Sure, it’s Matt. I can address that. First, every modification or negotiation is dependent on the specific facts and circumstances. It often hinges on what the borrower is willing to agree to, as well as the occupancy and cash flow of the specific asset. Typically, longer-term arrangements involve a more comprehensive solution. When we have a committed sponsor, there are usually funds coming in to reduce debt alongside our efforts to write down or subordinate some of our mortgage, which encourages payment and leads to a more sensible capital structure. This allows our sponsors to lease at a reduced basis from that new figure. Short-term extensions are generally used to facilitate a broader modification, loan sale, or foreclosure, or to allow us more time as we work on something else. I see longer terms as a sign that a resolution has been reached regarding that loan, at least in the short term, while the shorter terms indicate we're aiming for that resolution.

The next question comes from Don Fandetti with Wells Fargo. Please go ahead.

Hey Matt. Can you talk a little bit about your thoughts on multifamily credit? If the Fed has to raise, let’s say another 50 basis points, is that a manageable situation?

So, I think that taking a step back, even beyond multifamily, obviously this rate environment, as we mentioned in our prepared remarks, is creating a lot of pressure on values, pressure on sponsors, and you’re going to need a lot of liquidity to carry these assets through. As it relates to multifamily, specifically in our own portfolio, we haven’t seen any real challenges yet from the rate environment on that component of the multifamily portfolio. We’re watching it closely and certainly understand that the longer this period goes, obviously, the more stress or pressures is in the system. But I’d say, right now, we’re not really seeing it within our own portfolio. I do expect over time, taking a step out of KREF, but just broadly in the sector for floating rate loans secured by multifamily to have some issues, especially if you have a sponsor that doesn’t have a lot of liquidity to carry the asset through to a lower interest rate environment. That being said, if you think about the fundamentals of multifamily away from value and away from cap rates, we’re still seeing a lot of positive trends there. Occupancies remain high. We mentioned some of the rental increases year-over-year in our own portfolio within KREF. And obviously, if you go back further over a longer period of time to like 2021, you’re talking about high teen-type rental increases over that period. So, we’re still seeing positive fundamentals there. It’s still a very liquid asset class. The agencies are still heavily involved from a financing perspective. So, it’s got a lot of positives. But clearly, the rate environment is a headwind there. And we’ll continue to watch our portfolio closely to see if it creates any potential noise there. But, long-term value, I think we feel relatively good about that sector from a loan basis perspective.

The next question comes from Jade Rahmani with KBW. Please go ahead.

First one would be a broad question around cash flow from operations, the dividend, as well as attentiveness to covenants. So, in the quarter, cash flow did cover the dividend, which is a strong result. However, considering that the portfolio continues to shrink and with rates there is clearly the risk of further credit migration, the average earning portfolio should be smaller for 2024, and therefore, it would follow that cash flow from operations would be pressured. So, can you give any color as to your thinking around those two metrics? Secondly, as it relates to covenants, there are two main ones that come out. One is the interest coverage covenant, which is a function of interest income versus interest expense; and then the second would be liquidity as a percentage of loans. How are you feeling about adequacy on both of those?

Thanks, Jade. It’s Matt. I can jump in for the first one and then maybe Patrick can cover the second questions around the covenant. I think from a dividend perspective, like you’re highlighting some of the things that we highlighted in our own commentary, just about what some of the big drivers are going to be as we think about the go forward and over the next handful of quarters. Nothing’s really changed in terms of how we evaluate that dividend, and the Board makes a decision every quarter. We’re really coming at it from a run rate, operating earnings perspective as you’re identifying, and not really from like a liquidity perspective. So, as we start to go down the road here and understand what the market environment looks like, then we’ll make a decision at that point in time, but this is a very difficult market to be projecting that far out in the future in terms of what things may or may not look like. So, we’ll take it quarter-to-quarter, and the Board will make that decision.

Jade, this is Patrick, and I’ll follow up on the covenant question. So, you asked the question specifically with regard to interest coverage. That’s something that we’ve been monitoring. Frankly, the whole market’s been monitoring, because it’s so affected by the increase in SOFR. It’s just math; at some point that coverage becomes tighter. But we did proactively this quarter reduce that covenant from 1.5 times to 1.4 times. We still cleared the covenant this quarter without that adjustment, but I think it’s just an example of us being proactive around the covenants and that went smoothly with all of our financing partners. With regard to the other covenants, whether it be net worth or liquidity, as we’ve indicated in our prepared remarks, this quarter and past quarters, we feel really good on the liquidity side. And so, I don’t feel challenged on either of those covenants. So, really, interest coverage was the one that was most in focus and we made an adjustment this past quarter, just to give us further breathing room.

Thank you very much for both answers. The follow-up to Don’s question about multifamily. Do you know what the in-place debt yield is? Because the occupancy stats you cited and rent growth stats are very strong. So, I’d assume that it’s close to a stabilized debt yield. What’s the current debt yield?

I don’t have that information readily available, but we can connect offline to discuss it further. It's important to remember that we are at different stages in our business plan. We have recently leased and made loans on some newer assets that are still in the leasing process, and there are several assets undergoing renovations and upgrades. These properties are still in transition regarding what we consider fully stabilized cash flows, debt yield, and assets. But we can follow up with more details.

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

I’d love to talk a little bit about Mountain View and Philadelphia. Incrementally, it sounds like what’s changed at Mountain View is still considering the possibility of taking ownership, but perhaps doing it in JV structure, and Philadelphia sounds like the sale fell through. Now, you’re adding the possibility of taking ownership for at least portions of those properties as well. I’m curious, a couple of things. With those changes, incrementally in the context of what you expect your losses will be there, and again, category 5 loans, so you’re expecting losses. Do those developments increase or decrease your potential loss expectations?

Our reserves are updated each quarter. As these processes evolve, we make adjustments to the reserves accordingly. That's the basic answer to your question. We do not expect any changes regarding our current situation since those have already been considered.

Understood. I recognize that this falls under GAAP accounting, but from a probability standpoint, I assume you would evaluate whether these developments were slightly positive or slightly negative. The reserve still stands at two-thirds of the overall total, and since we don't know specifics about those three level 5s, aside from your general comment, I'm curious about what we should derive from this. It appears that the short sale not going through seems negative, suggesting you were prepared to sell the property at a loss but couldn't finalize that deal. I assume that decision wasn't made because you thought a better offer might come along.

I believe there are a few key points to understand. Firstly, the market is currently very illiquid, which is reflected in our reserves. Regarding the Philadelphia sale, although we engaged with a serious buyer and had a legitimate process, we remain cautious, knowing that nothing is finalized until it’s officially completed. We're also looking at another buyer for a portion of the properties, while the others are more stabilized and generating cash flow, which we might consider retaining. This gives additional context about Philadelphia specifically. However, I wouldn't interpret this as a definitive statement; rather, we are making an effort to provide transparent updates as the situation develops, aware that it is subject to change due to the market's lack of clarity and liquidity. We continuously update our reserves based on changes in the process and its impact on value. That sums up our current position on those two assets in particular.

Got it. I appreciate having a very imperfect crystal ball. I certainly struggle with that as well in terms of what we do. From a mechanical perspective, I value the intellectual integrity of restructuring the loan, creating a subordinated loan and writing it off immediately, rather than carrying it on the balance sheet and extending it. If and when you take possession of properties, do you generally expect to realize losses, or does it get deferred further as part of the resolution?

If we go to title, we would take a realized loss at that moment in time, based on an appraised value.

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

I apologize, I was on mute. I wanted to say good morning and congratulations on the Chicago office loan workout. It wasn’t one of the loans we had on our watch list, but it’s good to prevent a potential issue in the future, which I assume is why that action was taken. This brings us to the comments about the Washington DC loan that is being reworked, which may be addressed in the fourth quarter. Regarding that rework, and I know there are limitations on what you can say, do you expect that it will involve any sort of write-off to KREF as you establish a new facility for the borrower?

Yes. Thank you for joining today. Just to clarify, the Chicago office loan where we received a $15 million pay-down and then a $15 million subsequent write-off on our loan, that was a 4-rated loan. So, that is one of the watch list loans that… So I just want to make sure, that was clarified. And then, on the Washington DC loan that you’re highlighting, it’s not our anticipation that there would be any kind of write-off or consideration in conjunction with that modification.

It would be helpful if you could consider issuing an 8-K when dealing with these workouts. It demonstrates progress and allows analysts to quickly adjust their estimates before the earnings call. Regarding the DC loan, we don't expect any write-down. Matt, you mentioned rates and the overall strategy. The Fed hinted late last week that they might be done for now, suggesting the bond market at 5% has done its part. I'm curious if there’s a belief within KKR’s private equity sector that we’ve reached peak rates and they will likely decrease in the next year or two. If that’s the case, wouldn’t it lead to increased private equity and strategic investments in the U.S. commercial real estate market once the Fed eases its grip? What do you see as the relationship between the current rate situation and the potential influx of capital into U.S. real estate? Thank you.

We believe that once we navigate through this period of rising interest rates and the market gains clarity on where rates will stabilize, transaction volume will begin to increase. This trend is not limited to real estate; we are observing it across the entire KKR portfolio, including private equity and corporate credit infrastructure. It appears that we may be entering a different market environment concerning transaction activity and acquisitions. Simultaneously, we are noticing positive developments in the market, particularly in terms of capital influx from various fundraising initiatives. There is a shared understanding that significant opportunities exist in commercial real estate over the next year, and this is reflected in the ongoing capital formation.

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

Thank you for taking the follow-up. Just on CECL, in the third quarter, the economy performed really well, including on the employment side. That’s a tailwind for the CECL macro component. In 4Q, things should slow and we also have the treasury rate spike. So, do you think that alone drives an increase in just the macro component of CECL in the fourth quarter?

It’s Matt again. That’s a tough one, Jade. I would say it’s hard to predict what the macro output is going to be at this point and how those different paths look. And part of the model is not just macro in terms of GDP, employment, interest rates, it’s also CRE prices, which have adjusted a fair amount, as you know. So, it’s difficult to say, it certainly could happen, but it’s not something like we spend a lot of time thinking about or forecasting in terms of what the next macro modeling CECL reserve is. I think we’re much more focused on loan by loan, outcomes from an asset management perspective and what we can control.

Thanks. I just have an office question. In the third quarter, there were definitely some green shoots in leasing within certain markets and also within a subset of best-in-breed type properties. Some landlords also have said they’re going to moderate TIs and it looks like there’s a little bit of relief in our tracking on free rent. How would you characterize the major office trends you’re seeing?

I believe the numbers you mentioned are likely a better reflection of the broader market trends since our portfolio is relatively small, and we are primarily focused on a few sold assets. Overall, our impression of the office space assets is that the leasing conditions are improving more than the capital markets expect, indicating that there is a demand for office space. While costs are high, they are still manageable from a lender's perspective. Thus, we feel that the situation is somewhat more positive than many people perceive.

Thanks for that. And then a technical question, when I look at the slide deck, it shows $152 million of repayments, but the cash flow statement subtracting the nine months from the six months implies $43 million. Is the difference timing related or something else?

Jade, it’s Patrick. That has to do really with the Oakland partial pay-down that Matt had referenced. On that deal, we originated a whole loan, sold a first mortgage, and we retained a mezz. So, that difference is due to the fact that we own a mezzanine loan. And so, while we’re showing that pay down reflective of that full loan balance, the reality is we just own the mezz portion.

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. And thanks everyone for joining today. Please reach out to me or the team here, if you have any follow-up questions. Take care.

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