KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q1 2023 Earnings Call Transcript

KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q1 2023 Earnings Call Transcript April 25, 2023

KKR Real Estate Finance Trust Inc. beats earnings expectations. Reported EPS is $0.48, expectations were $0.47.

Operator: Good morning, and welcome to the KKR Real Estate Finance Trust Inc. First Quarter 2023 Financial Results Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Jack Switala. Please go ahead.

Jack Switala: Great. Thanks, operator, and welcome to the KKR Real Estate Finance Trust earnings call for the first 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 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 first quarter of 2023, we reported a GAAP net income of $30.8 million or negative $0.45 per diluted share, including a CECL provision of $60.5 million or $0.88 per diluted share. Distributable earnings this quarter were $33.1 million or $0.48 per share. Book value per share as of March 31, 2023 was $17.16, a decline of 4.7% quarter-over-quarter. Our CECL allowance increased to $2.48 per share from $1.61 per share last quarter. The increase was primarily due to additional reserves for two 5-risk rated office loans, where the sponsors have commenced sales processes for the properties as well as heightened market volatility, uncertainty and reduced liquidity, particularly in the office sector.

Finally, in March, we paid a cash dividend of $0.43 per common share with respect to the first quarter. Based on yesterday’s closing price, the dividend reflects an annualized yield of 15.5%. With that, I would now like to turn the call over to Matt.

Matt Salem: Thanks, Jack. Good morning, and thank you for joining us today. KREF generated strong distributable earnings this quarter of $0.48 per share relative to our $0.43 per share dividend as our 100% floating rate portfolio continues to benefit from the high interest rate environment. As you have heard us say for the last few years, we have been hyper-focused on our liability structure and liquidity. This focus has created best-in-class non-mark-to-market financing and very high levels of liquidity. Maintaining KREF’s defensive posture remains our primary focus today given current market dynamics. Rising interest rates and recession risks continue to weigh on real estate transaction volumes and valuations. Beginning in the summer of last year, the largest money center banks were largely inactive.

And since our last earnings call, we have seen two large regional bank failures. While KREF does not have any financing or direct exposure to regional banks, we do expect this to cause tightening credit conditions as regional banks take a more conservative posture and regulators increase their oversight. The expectation of tightening credit conditions has weighed heavily on nonbank financial institutions and created a narrative around already declining real estate valuations. In our own portfolio, our asset management focus is on our loans secured by office properties. We have increased reserves this quarter and put two more office loans on our watch list with a risk rating of 4. The office sector continues to be challenged with limited liquidity and values down significantly.

Given KREF’s high levels of liquidity, we have taken a proactive approach in working through resolutions on our identified loans with our sponsors. Our approach has been direct, and we are leveraging the full resources of KKR to optimize outcomes. But to be clear, we are not looking to kick the can down the road. Where we find reasonable liquidity and valuations, we will transact. However, we’re not forced sellers. So where there is little liquidity, we will take title and manage the property at a lower basis. Patrick will discuss updates to our watch list in detail later in the call. As we signaled last quarter, we expect the portfolio to turn over modestly throughout 2023. In the first quarter, we received loan repayments of $87 million and funded $204 million for loans previously closed in previous quarters or net increase of $117 million.

Our portfolio is built defensively with focus on resilient property segments of the market. Nearly 60% of our portfolio at quarter end was comprised of multifamily and industrial properties. We had no new loan originations this quarter as we look to maintain our robust liquidity position. Our partnership with our manager, KKR and the strength of our real estate platform allow us to maintain a sophisticated view of the current operating environment. We have a dedicated team of approximately 60 real estate credit investment professionals. Beyond KREF, we are actively lending for our bank and insurance SMAs as well as our private debt fund. This diversified capital base allows us to stay active in the market and service a strong client relationships.

As a result of our defensive posturing, KREF was one of the first mortgage REITs to begin lending during COVID, and we feel we are well equipped to utilize a similar playbook when the market stabilizes. Also worth noting is our manager’s long-term hold position of 10 million shares in the company or approximately 14% of KREF shares outstanding today. We believe this is the highest ownership percentage held by manager in the mortgage REIT sector and demonstrates meaningful alignment between KKR and KREF. As I mentioned earlier, we were operating KREF with a high level of liquidity with nearly $1 billion as of March 31, including $254 million of cash and our $610 million corporate revolver, which was undrawn at quarter end. As we have discussed in prior quarters, we added over $4 billion of additional non-mark-to-market capacity over the past two years with the support of the KKR Capital Markets team.

Approximately $2.5 billion was added in 2022, 2/3 of which was done on a truly bespoke basis with financing providers such as foreign banks and insurance companies and away from public capital market sources. 76 of our secured financing at the end of the first quarter of 2023 was completely non-mark-to-market and diversified across a number of facilities and the remaining 24% is only marked to credit. With that, I’ll turn the call over to Patrick.

Patrick Mattson: Thank you, Matt. Good morning, everyone. I’ll focus today on our efforts on the liquidity and capital front. But first, let me provide an update around our CECL reserve and watch list loans. This quarter, we recorded a $60 million increase in our CECL reserve for a total reserve of $172 million or 224 basis points of our loan principal balance. Slightly more than half our total CECL reserve remains held against the two 5-rated office loans. We have a total of 7 loans on the watch list as of quarter end. As we detailed previously, we executed a modification of a Philadelphia office loan earlier this year and subsequently removed it from the watch list this quarter as anticipated. During the quarter, we downgraded two office loans to a risk rating of 4.

And consistent with past quarters, we highlight those loans in our earnings supplemental. Touching on our two 5-rated office loans in Minneapolis and Philadelphia, the respective sponsors have commenced sales processes for the properties, and we increased our reserves this quarter to reflect further weakness in the office sector. As Matt mentioned, we will evaluate the prices and determine the appropriate path forward with the option to sell or own and manage the properties ourselves. In either case, we anticipate some resolution in the coming months on both assets. The two new watch list loans are secured by properties in two of the more challenged office markets, Washington D.C. and Chicago. That said, both properties have experienced positive leasing momentum recently.

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The DC loan, which is the larger of the 2, is backed by a well-located Class A office near Dupont Circle and following two recent leases is 84% leased. The Chicago property is also a Class A asset and is located in the central loop submarket. Following some known vacates, along with 83,000 square feet of recent leasing, the property is currently 70% leased. Of the 14 office loans, eight loans in our portfolio, equating to half of the outstanding principal balance are risk rated 3. This segment of our office loan portfolio is 89% Class A and 91% leased with a weighted average debt yield of 8.3% and a median 8.8 years of weighted average lease term remaining. The average risk rating of the company’s broader portfolio was 3.2, consistent with year-end.

87% of our portfolio is risk rated 3, and we collected 100% of scheduled interest payments across the entire portfolio in 1Q and through the April payment date. An important differentiator for KREF, particularly in times of capital markets volatility is how we finance our senior loan portfolio. At quarter end, our diversified financing sources totaled $9 billion, with $2.7 billion of undrawn capacity. 76% or outstanding financing is fully non-mark-to-market and the remaining balance is marked to credit only. KREF is differentiated in the diversity and resiliency of these sources, which includes not only two managed CRE CLOs but also multiple bespoke financing facilities supported by a number of financing partners. We are not reliant on a single type of financing with no outsized exposure across any of these categories.

Additionally, in the first quarter, we extended a $600 million repurchase facility by two years to December 2025 and a $500 million warehouse facility to March 2026. In a challenging macro and banking environment, we were able to extend an aggregate $1.1 billion in financing by roughly 2.5 years between the two facilities. KREF is well capitalized with a debt-to-equity ratio of 2.2x and a total look-through leverage ratio of 4x as of quarter end. As of March 31st, we had $254 million of cash and $610 million of undrawn corporate revolver capacity. In addition to this, we had $100 million of unencumbered and unpledged senior loans, plus underdrawn capacity on our credit facilities, bringing our total liquidity position to nearly $1 billion. As noted, we have cash on the balance sheet plus ample capacity on the revolver to retire our May 2023 convertible notes maturing next month.

Following the convertible note maturity and excluding match term secured financing, KREF has no debt maturities for nearly 2.5 years. Thank you for joining us today. Now we’re happy to take your questions.

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Q&A Session

Operator: And the first question will be from Don Fandetti from Wells Fargo. Please go ahead.

Don Fandetti: Can you talk a little bit about the new 4-rated loans and what sort of drove you to move those? And then I guess, are we looking at just a scenario where every quarter you’re getting migration to the 4s and 5s. Why not just build more reserves today just given the economic environment and the pressures in office?

Matt Salem: Don, it’s Matt. Thank you for joining, and I can start by addressing that first question around the new loans that we moved to a risk rating of 4. When you think about the overall office exposure, certainly, it’s not our expectation that we’ll continue to see all those loans migrate. And I think Patrick did a nice job summarizing why some of the loans that remain a three within our office portfolio, they’re well leased, long-term leases and some of which are in extremely strong markets as well from an office perspective. So just as you start to think about the transition and certainly not our expectation, we look at it every quarter and are kind of evaluating all the loans in the portfolio for any changes, but there’s a big component.

About half of that currently, that we still feel very comfortable with on the office side. In terms of the ones we did transition over, I think that those 2, in particular, are in some of the softer markets for office, obviously, DC has got the impact of GSA and work from home policies of those tenants. And Chicago is a particularly weak market as well. And so that was a lot of the reason why those were transferred in at that time even despite some of the leasing momentum we’ve seen at those assets.

Don Fandetti: Thank you.

Matt Salem: Thanks.

Operator: And the next question will be from Stephen Laws from Raymond James. Please go ahead.

Stephen Laws: Hi, good morning. Matt or Patrick, can you talk about the reserve and kind of how we should think about that allocated across the 5s and 4s versus maybe a general for the remainder of the portfolio? And then if we read into that kind of new – read in kind of that rough allocation, what valuation does that imply for the 5-rated assets versus the valuation of the origination?

Patrick Mattson: Stephen, good morning, it’s Patrick. I’ll take that question. So yes, if you think about our 5s, what we had indicated was about half of our total reserve, a little bit more than half of our total reserve is allocated to those. And then if you just sort of apply the math there, that implies a loss on those loans in the kind of magnitude of 25% to 30% against those 5-rated loans. If you remove those loans from the portfolio and look at our remaining CECL, it’s about 1% across all of our remaining assets. Now there’s obviously some concentration with our 4s because those are attracting a higher reserve than our three assets. But hopefully, that gives you some sense of direction. Clearly, when the assets move from a four to five, we’re seeing sort of a jump in our reserve and sort of loss expectation, and that’s reflected in our reserve analysis.

Stephen Laws: That’s helpful. I appreciate that, Patrick, the comments there. With the many assets specifically next month maturing, I believe, and maybe even kind of apply this broader across the watch list loans. But how – can you walk us through the process of how you determine what makes more sense as an REO, how you go about finding a new sponsor, maybe to recap one of these deals and provide seller financing? How early can you start those discussions ahead of these watch list problem maturity dates? And maybe some color on how that process will play out on these handful of loans in the coming months.

Matt Salem: Sure. It’s Matt. I can take that. Thanks again for the question, Stephen. So specifically on Minneapolis and the two 5-rated loans and our Philly asset as well, those are instances where the existing sponsor is running a full sales process. And we’re able to obviously modify and give short-term extensions to help effectuate those transactions. And we’re also able to provide the market with information around where we’d be willing to provide financing on the potential acquisition. So there’s a lot of flexibility there. In terms of how we think about owning versus potentially a sale and a finance is we’re running very detailed analysis, similar to what the real estate equity team on – within KKR would run in terms of what does the go-forward look like from a return perspective, factoring in the current market environment for leases and kind of improvement costs and leasing commissions and cap rates, obviously.

So we’re just evaluating all that information to make a buy or effectively a buy or sell decision at this point in time.

Stephen Laws: Great. Appreciate the color on that Matt. Thank you.