Earnings Call Transcript - KREF Q1 2021

Operator, Operator

Good morning, and welcome to the KKR Real Estate Finance Trust Inc., First Quarter 2021 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, sir.

Jack Switala, Head of Investor Relations

Great. Thank you, operator. Welcome to the KKR Real Estate Finance Trust earnings call for the first quarter of 2021. We hope that all of you and your families are safe and healthy. As the operator mentioned, this is Jack Switala. I recently joined KKR and going forward will serve as the Head of Investor Relations for KREF. I'm looking forward to connecting with you directly.

Matt Salem, CEO

Thank you, Jack, and welcome to the team. Good morning, everyone, and thank you for joining us today. We hope you are all healthy and safe. KREF is off to a great start this year, in terms of financial results—another outstanding quarter with distributable earnings of $0.55 per share covering the $0.43 dividend by 1.3x. This is a continuation of the success we had in 2020, where distributable earnings covered our dividend by over 1.1x, despite the global pandemic. Our earnings continue to benefit from strong portfolio performance and existing LIBOR floors. We're seeing good progress on property business plans, which we expect to lead to elevated repayments in the back half of the year, after which earnings will begin to normalize. On the origination front, we remained active with a continued focus on high-quality real estate owned by premier sponsors. In the first quarter, we originated three loans totaling $535 million, comprised of two office properties and one multifamily property. Net funding this past quarter exceeded $330 million and our portfolio grew to over $5.3 billion as of March 31.

Patrick Mattson, CFO

Thank you, Matt, and good morning, everyone. As of quarter-end, a market-leading 76% of our asset financing remains completely non-mark-to-market, and the 24% remaining balance is always subject to credit marks. Also, as of quarter-end, our debt-to-equity ratio and total leverage ratio were 2.1x and 3.7x respectively. Following the preferred stock rates, our debt-to-equity ratio and total leverage ratio sits at 1.7x and 3.1x respectively today. But we expect our leverage ratios to return to the first quarter range in subsequent quarters as we invest the new 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 an updated risk rating. The current portfolio risk rating of 3.11 on a five-point scale is consistent with the weighted average risk rating last quarter. As we've done in prior quarters, we continue to provide a detailed breakout of our watch list loans in the supplemental presentation. Notably, 89% of our loans are now risk-rated three or better, which has improved from 84% in Q4. The improvement is the result of two four-risk-rated loans being upgraded to a three-risk rating in Q1, specifically, the Fort Lauderdale Hotel loan and the San Diego multifamily loan. Furthermore, we are seeing improving trends in additional properties, which may lead to positive credit momentum in other assets. Approximately 2% of our portfolio is risk-rated five and is primarily comprised of our Portland retail loan. While the property remains challenged, we continue to dialogue with existing and prospective sponsors regarding the next phase of the property. And we continue to believe there are adequate CECL reserves. We received approximately $244 million of repayments in the first quarter and while it's always difficult to predict repayments with certainty, consistent with our comments last quarter, our expectation remains for increased repayment activity in the second half of the year. In the near term, KREF should continue to benefit from its in-place LIBOR floors and elevated effective net interest margins. While the portfolio is almost entirely floating rate, currently, 69% of the loan portfolio has a LIBOR floor of at least 1% and half of the loan portfolio is subject to a LIBOR floor of at least 1.65%.

Operator, Operator

We will now begin the question-and-answer session. And our first question today will come from Jade Rahmani with KBW.

Jade Rahmani, Analyst

I was wondering, Matt, if you could just put a little color around your comments that in the back half of the year elevated repayments after which you expect earnings to normalize. Are you saying that earnings can be elevated in the back half of the year or under pressure in the back half of the year?

Matt Salem, CEO

Jade, thank you for the excellent question. I think as we look forward over the next couple of quarters, we still feel like earnings could be elevated as we sit with the existing portfolio and the embedded LIBOR floors. We're seeing that our best guess—and it's difficult to predict for sure—but our best guess right now is that in the third and fourth quarter, we'll have some pretty heavy repayments and so once we get through those quarters, that's when you'll start to see more normalization of earnings.

Jade Rahmani, Analyst

And will those repayments have an earnings benefit from accelerated prepayment income?

Matt Salem, CEO

Yes. I mean, we'll get some of that. We will come through, obviously in that particular quarter, and then, following quarter, obviously, we're not benefiting from those LIBOR floors anymore and the excess NIM, but in those quarters they pay off, we'll see a little bit of that come through.

Jade Rahmani, Analyst

And the weighted average IRR of 13% to 14% on the pipeline, how does that compare with the IRRs the company has historically generated?

Matt Salem, CEO

Yes. If you wanted to think about the market environment today, I guess comment one would be the pipeline is very large. So there's lots of opportunities to look at. So that's certainly a positive in what we're seeing; the competitive environment is high. And you certainly see spread and yield compression in the market. That being said, the way we finance ourselves, there's also a lot of competition in that market. And you've seen the cost of capital from the debt side compress. And so you asked about kind of the ROE that we saw kind of in the pipeline, I would say that's slightly higher than what we saw pre-COVID. My guess is some of the loans that we're doing over the next couple of quarters will look a little bit more like we did pre-COVID, so closer to that 11% to 12% all-in IRR context, just as our expectation of the competitive pressures on the market continue.

Jade Rahmani, Analyst

And just the last question would be, in terms of capital management, capital issuance, the preferred stock issuance with the stock at about 6% above book value, what level would it make sense to issue common equity?

Matt Salem, CEO

Yes. I think we've been pretty disciplined in the past about accessing the market when it's only accretive to the stock. The preferred equity issuance, it took a lot of our near-term or solved for a lot of our near-term needs for liquidity. So we had a developing pipeline. On the last call, we mentioned we were focused on equity and we were able to execute a really successful deal on the preferred. So looking ahead and what we're really trying to balance is our expectations of these repayments. And so, as we start to think about the third and fourth quarter and heavy repayments, I'd say that takes a little bit of caution in terms of raising equity here in the near term, because we did the preferred. We can certainly take care of our existing pipeline and then we'll start to get into a repayment schedule. That's not to say things can't change; our pipeline could continue to grow beyond what we think our repayments are, but that's how we're thinking about it in the near term.

Operator, Operator

And our next question will come from Stephen Laws with Raymond James.

Stephen Laws, Analyst

I guess first maybe to follow up on Jade's questions just kind of, I realize these are all unique loans, but and certainly could be coincidence. But when I look at the subsequent to quarter-end loans, it looks like a much lower percentage of that loan was funded than your originations in Q1. As you try and manage your pipeline into that refinance or repayment wave in the second half, are you actively trying to increase the unfunded commitment balance to have those draw-downs take place in three or six months or 12 months? Is that something you look to do or is that just coincidental with the post-2Q originations or post-3/31 originations?

Matt Salem, CEO

I think having some base level of future funding is appropriate and takes a little bit of the pressure off quarter-over-quarter originations. That being said, I think what you're describing is a little bit more coincidental and it's a little bit in response to some of the market opportunities you're seeing. Most of that future funding is coming from our participation in the industrial sector of the market, where we've rolled out a program where we have some construction lending for, obviously, new build industrial. So that's driving most of that, not all, but most of that kind of future funding component that you're seeing in terms of change quarter-over-quarter. So, it's a sector that, historically, we haven't lent a lot on, but obviously, with COVID, it's a big accelerated sector, and with e-commerce, we think it's a really attractive opportunity set. And so we've done a couple of deals and that's driving that number.

Stephen Laws, Analyst

Great. And then, picking up on common apologies, I hadn't made it through the entire Q yet. What was pick income for the quarter, and then maybe how did that change from a year-over-year basis, which would obviously be a very tough comp for most companies, then maybe how did that change on a sequential basis?

Patrick Mattson, CFO

Stephen, it's Patrick, I'll talk about that. So on the pick income, we saw a little bit of change in the first quarter, it's really driven by just a couple of assets. I think we've talked about some of these assets in the past, including our one hotel loan in Brooklyn, as well as a condo loan in New York. So we've got about $3.3 million in total. I would note that in the quarter, we also saw a reversal of a pick; one of our hotel loans or other hotel loan, which is the Fort Lauderdale hotel loan got modified. There was a $10 million pay down, the true-up of the pick balance, and that loan is now current going forward. So it's a modest amount that we had; I think the net change was about $850,000 for the quarter.

Stephen Laws, Analyst

Okay, great. So pretty small debt, especially relative to some peers. Thanks, Patrick. Matt, last question, maybe on the four loans, two New York residential, Brooklyn hospitality, Queens Industrial. Can you maybe just talk about New York? You guys were there feet on the ground. So can you maybe just give us a bigger picture in New York and how you guys are seeing things as far as the reopening and people returning to the office and other things like that, just given you guys are all based there?

Matt Salem, CEO

Sure. Well, I think you're just starting to see the reopening, as you mentioned, and that's impacting, I would say first and foremost multifamily, where you've seen a number of folks obviously that moved out during the pandemic. I think you're starting to see the repopulation return as these offices open. And I think New York is a little bit more slow—it's probably opening more slowly than some of the other markets with people opening. We are there a little bit now, but there's a lot of talk about opening fully in the fall from a lot of tenants. But you're just starting to see apartment prices stabilize, and start to go up a little bit. We've seen some concessions come down in the apartment sector. I think the office market is still delayed in terms of trying to understand where rents are resetting, where sublease rates are, and where occupancy will settle in, which has led to a little bit more uncertain times. And I said the financing markets are cautious, especially in the office sector and in New York still. You can see the embedded assumptions and the people are making about new loans are very conservative in Manhattan. In terms of the asset qualities or property types, when we think about the condo, I think the condo inventory loans that we have, the two that you mentioned, you're the one that has product readily for sale; it's a little bit later in its business cycle versus business plan. We've seen a lot of progress and velocity. I think you're seeing that across the market. Certainly you can read articles in terms of how much velocity there is in condo sales in New York now, and we've certainly seen that at our property. I think we've had almost $50 million of sales since COVID and there are a number of units still under contract that haven't closed yet. So certainly positive in that regard, and I think it just shows you that if you lower prices, as the market comes down to meet the market, you can certainly sell units, and there's liquidity and clearing levels. Those are the comments I'd make around New York.

Stephen Laws, Analyst

Great. Appreciate the color there. Thanks for the comments, Patrick, and congratulations on a nice quarter and the recent capital raise.

Operator, Operator

And our next question will come from Tim Hayes with BTIG.

Tim Hayes, Analyst

Matt, I just want to circle back to my first question around, I think you might have made a comment about kind of funding costs and how that relates to the all-in-all leads you're seeing on new loans versus pre-COVID. But, are you seeing repo costs come down and/or advance rates move up as the banks are competing with a very hot capital markets backdrop right now? And then, just Part B to that is, a lot of your peers have executed on CRE, CLOs this year? And just curious with your light transitional strategy, I know you already have done one before, but how you feel about that financing strategy in the near term as well.

Patrick Mattson, CFO

Tim, good morning, it’s Patrick, I'll take both of those. So first, on the financing cost, yes, we are seeing compression on the liability side. Sometimes these don't always move in tandem, and sometimes there's a delay in what's happening on the asset side. But we're certainly seeing across the board repo spreads compress in the market. I think in part, that's driven by what's happening in the broader securitization market including the CLO side. I think this has been a very active year on the CRE, CLO side, as you noted, some of our public and private peers have accessed this market, we're seeing one or two deals come to market a week. So very, very active and is a very efficient cost of capital. So that's a market that we continue to track closely. We have a very attractive cost of capital on our existing CLO. We haven't had a lot of repayments to date. So even though we're past reinvestment periods, we're still benefiting from that very attractive cost of capital. But we're encouraged by what we're seeing on the liability side, in particular, in the CRE, CLO market, as we're thinking about financing needs over the course of this year.

Tim Hayes, Analyst

Got it. That's helpful. And, I guess we'll see what happens there. But just based on kind of what I guess the velocity of those spreads coming in and maybe what you could expect? Do you think that the trajectory in funding costs would, just partially offset the pressure on asset yield you're seeing as repayments are recycled into new assets, tighter spreads, or lower basis? Or would it partially offset, fully offset, or more than offset? Just curious kind of what your expectations are there. And I guess, just a little more broadly, I'm trying to see if it's really the spread, the NIM spread that's coming in, that's going to put—bring earnings power to more normalized levels next year, or is it really just maybe expectations for portfolio contraction as repayments pick up?

Matt Salem, CEO

Sure. So I think about the offset as being sort of partial to what's happening on the assets spread. I think you also have to separate a little bit of the current effective NIMs that we have in the portfolio, which are a real benefit of these LIBOR floors. So when we originally underwrote those loans, that's not the NIM that we were anticipating, but obviously, we've gotten the benefit for over the last year and a half or so. So if I compare that to some of the pre-pandemic levels and think about that from a NIM standpoint, it's not actually very different from the pre-pandemic market; we're seeing NIMs that are on a relative basis very attractive. I think if we try to compare them to our effective NIMs today, it will look like a lot of compression. If you look at it, in comparison to the market pre-pandemic and before we saw a really dramatic drop in LIBOR, they're actually very comparable. So we're obviously pleased with that and the level of activity that's happening on the liability side. I think the other thing that we will likely get the benefit of as some of these loans pay down with these higher LIBOR floors. As I mentioned in the opening remarks, we're resetting new LIBOR floors to the current spot rates. So 10 to 15 basis point LIBOR floors, which means that at some point in the future, if and when LIBOR does rise, we'll have some positive correlation within the portfolio to that rising LIBOR, and we'll get some positive benefit in a higher rate environment.

Tim Hayes, Analyst

That one makes sense. And I can go back and see kind of what given in coverage looked like, before COVID, and that's kind of where NIM is expecting to trend; we can kind of attune it together. But I'm just curious if you could just provide some comments around your expectations for dividend coverage, as we get to that more kind of normalized earnings run rate early next year.

Matt Salem, CEO

Yes. I think our pre-COVID sort of quarters where we were fully deployed, I think are fairly representative. That said, it's really early to think about that and how that all transpires over the next year or so. So, I think our expectation is that they will normalize, i.e., that some of the elevation that we've had in these earnings will sort of come down. But I think in terms of exact levels in terms of coverage, I think it's too difficult to predict at this point.

Tim Hayes, Analyst

Sure. Okay. And then just on credit, I know you made some comments earlier, but can you maybe give us an idea how interest collection or just rent collections and properties underlying your portfolio have trended so far in April, relative to the first quarter?

Matt Salem, CEO

I think on some of the April numbers, it's probably a tad early to get all of that sort of flow through. I would say that from an interest collection standpoint, it remains the same two loans that we're not collecting on, which is the five-rated loans. I think when looking at the underlying properties, if I look at some of the occupancy trends that we're seeing, particularly on the multi-family assets, we're seeing positive improvement there from the later quarters of last year. So I think that's encouraging. So directionally, I think it's positive. I don't have an exact figure in terms of what those collections have been, but they've been very high across the portfolio; we've seen very little issue with sort of tenant collections at our assets, and I expect that trend to continue.

Tim Hayes, Analyst

Great. Well, appreciate the color there, guys. Congrats on a strong quarter.

Operator, Operator

And our next question will come from Charlie Arestia with JPMorgan.

Charlie Arestia, Analyst

Most of them have been covered already, but wanted to follow up, I guess, on Tim's question on the financing side, or I guess realistically asking a similar question in a different way. You guys closed the term loan late last year at like L plus 475, and I think there was a 100 bps floor on that. When you look at the new loans that are coming on the portfolio that are inside those spreads, and overall the more diversified funding structure that you guys have beyond the traditional warehouse lines, can you just talk a bit about where you see loan origination spreads directionally going from here? And I guess ultimately, how you see the economics of those new loans coming on the book, flowing through to the bottom line versus your all-in funding costs?

Matt Salem, CEO

I could take the first part of it, and then kind of hand it over to you. I would say on the new origination front for light transitional assets, we're seeing all-in coupons, call it in mid to low 3% context right now. And we've been craving a little bit more return than that playing in some of the sectors we like, like industrial, for instance. We can catch a little bit more return there and that's on the construction lending side. But I would say in that call 3%—mid, low 3% context are light, very light transitional assets right now. Patrick, I'll hand it over to you for the second part.

Patrick Mattson, CFO

Yes. On the financing side, Charlie, the term loan B obviously is one piece of our diversified financing structure. I think we're encouraged by what we're seeing in that market. We've got a soft call date that expires September 1 of this year. We think that there are potentially a number of deals that we'll see fresh pricing points between now and then. But we're encouraged by what we're seeing in that market, and obviously, there's an ability to reset. But it's one component of what we're doing. We think about that cost of capital holistically, and you'll see that we've got a range from our repo facilities to the CLO to the term loan B that all aggregate to form this kind of weighted average cost of capital. I think you've seen we've been very disciplined about diversifying it, but two, driving costs down over time.

Charlie Arestia, Analyst

Got it. Okay. Thanks for that. And then, just switching gears real quick, looking at the forward pipeline, I saw one of the new April loans secured by a single family rental portfolio; we'd love to get your thoughts more broadly on that property type. It seems like it's been a real growth area over the last couple of quarters post-COVID and kind of just curious to get your outlook on the competitive environment there.

Patrick Mattson, CFO

Yes, Matt, I can take that one. Yes, it's a sector we like a lot, obviously one of the COVID-accelerated areas as well. And so, when you think about what we're doing across industrial, life sciences would certainly be another area that has benefited from the pandemic. This particular loan is for building to rent for an institutional sponsor that we covered pre-pandemic. It's a unique opportunity within Phoenix. This is an area that has a lot of single family rental broadly—it’s got a lot of access to liquidity across both debt and equity. So I don't see this as being a very large part of the portfolio, but we'd like the sector. If we can find opportunities like this, we will continue to do these. But there's a lot of liquidity in this sector, so we'll have to find kind of pick our spots in terms of where we can create returns and the risk profile that makes sense for us.

Operator, Operator

And our next question will come from Don Fandetti with Wells Fargo.

Don Fandetti, Analyst

Yes. Jack, congratulations on the new role. Matt, on the Fort Lauderdale hotel, can you remind us where RevPAR or occupancy was pre-COVID, where it's sort of dipped and where we are today, just to give a sense of the recovery there?

Matt Salem, CEO

Don, thanks for the question. Let me pull that up. Have those numbers off the top of my head. Let me give you the current month; occupancy was in the 70s, ADR in the high three hundreds. So RevPAR was in the very high two hundreds. If you look back to a stabilized number, we could call it pre-COVID; occupancy is in line with that and ADR is actually higher. So our RevPAR for this current month is ahead of calling T-12 pre-COVID. Now, keep in mind, this is obviously a good time to be in Florida in terms of vacations and things like that, so we would have expected that, but the performance has been very strong. Clearly the sponsor here is committed to the asset with the most recent modification coming out of pocket and paying off the accrued interest that we had or the pick interest and delevering the loan by $10 million. So we upgraded this loan from a four to a three based on all these performance and the most recent modification, etc., so.

Don Fandetti, Analyst

Got it. Thanks for the details. I guess also on the shift to a little bit leaning towards industrial. I would think that sort of these developments that you mentioned are in the pipeline for e-commerce would be pretty competitive. Are you seeing a lot of competition in those types of deals? Or is there enough construction risk to where you can create some value?

Matt Salem, CEO

It's a competitive sector, but it does feel like there's a lot of opportunity here. The construction component of industrial obviously is a little bit more simple than a multi-storey building, whether that's multi or office. However, just the fact that it is construction does limit the capital base, especially from some of the regulated institutions. I think there's certainly opportunity here, and if you think about the equity side of our business, we have millions of square feet of exposure and market knowledge. So I think it works nicely with our overall theme of investing in areas that we have a lot of knowledge that we can use to overlap from what we're doing on the equity side, on the credit side and vice versa. So I do think we're certainly seeing a lot of opportunity just given the increase in demand in that sector; I’m hoping that will continue through the year.

Operator, Operator

And our next question will come from Steve DeLaney with JMP Securities.

Steve DeLaney, Analyst

I would also like to welcome Jack; we look forward to working with you moving forward. Guys, obviously, everything has been covered pretty thoroughly. The only thing I have left on my list is the 1.6 million reduction in the CECL provision. Is that specifically related to the two, four loans that were upgraded to three? And given that there are several other four rated loans? If those would also be upgraded, could there be additional CECL recoveries in the year ahead? Thanks.

Mostafa Nagaty, Senior Executive

Good morning, Steve. This is Mostafa Nagaty. Hope you're doing well. Thanks for your question. Yes, good question. So we're going to stick to the CECL obviously, we had the $1.6 million benefit. This resulted in this net decrease in our reserve quarter-over-quarter for most; it's really that macroeconomic scenario that we implemented this quarter, which is pretty much in line or slightly better than prior quarter. So that's resulted for a good portion of the increase. There were some offsetting factors, I think on some of the upgrades that we had, namely the Fort Lauderdale hotel that also resulted in a good portion of the decrease. That will also be offset by some of the originations; keep in mind that this quarter our originations were double the repayments. So there were some offsetting factors, but I think the two key factors here kind of the upgrade for the hotel loan that you just touched on as well as the macroeconomic assumptions.

Steve DeLaney, Analyst

Okay. Well, I know you guys have taken a lot of questions. So I will leave it there. It sounds like you're in a great position set up for 2021. So congratulations. Thank you.

Operator, Operator

And our next question will come from Arren Cyganovich with Citi.

Arren Cyganovich, Analyst

You mentioned your pipeline is fairly large and you've had some nice activity post-quarter. What's the activity of the sponsors? Are you seeing that kind of continue to increase? Are the sponsors coming with a lot of similar type properties? Are you seeing a more broadening of sponsor activity related to your business?

Matt Salem, CEO

I definitely think we see increased activity from all of our sponsors. That's just a continuation really of—I'd say what we saw in the fourth quarter of last year, certainly ramping up into this year. I think there was a lot of pent-up demand, both on the refinance side but as well as on the acquisition side, and the flow of capital continues in the alternative space and specifically within real estate. If you think about the real estate setup right now from a macro view, in a low-interest rate environment, where there's potentially long-term concern around inflation, real estate sets up pretty nicely—it's got a yield component to it and can be a hedge against inflation. So our expectation is that you'll see continued capital flowing into the sector, which will obviously benefit our sponsors and create the activity for us. In terms of where we see the focus, it's similar to what I think we described on the call; there's a lot of haves and in the real estate world now that there's a much clearer bifurcation between the haves and have nots. And so sectors with the most interest are all the housing sectors; obviously multifamily, single-family, rental, I think there's a lot of demand coming back for student housing as schools announce their back-to-school programs for the fall. The senior housing is probably a little bit behind all that, given the unique impact of COVID on that sector. But then, you're seeing things like life science, industrial, a lot of activity in those sectors. And that's not just from the capital base, it's obviously from the tenant base as well, that's driving this activity. There's a real need for converted space or new space in some of these sectors, which is great for our capital base because that's really what we're set up to do is to thrive on that level of transition. I still think there's a big question mark for most of our sponsors around how to play some of the office sector and how to play the retail sector. Obviously, the retail sector is not something we've historically been involved in. But, certainly, you've seen a big pause here for the obvious reasons. So I'd say nothing too unexpected, just continued activity and a real focus on where people have identified growth.

Operator, Operator

Then this will conclude the question-and-answer session. I'd like to turn the conference back over to Jack Switala for any closing remarks.

Jack Switala, Head of Investor Relations

Great. Hey, everyone, thanks for joining our call today. Feel free to reach out to me or the team here with any follow-ups. Thanks, everyone.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.