KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q4 2023 Earnings Call Transcript

KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q4 2023 Earnings Call Transcript February 7, 2024

KKR Real Estate Finance Trust Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, and welcome to the KKR Real Estate Finance Trust Fourth Quarter 2023 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] 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’s earnings call for the fourth 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 Web site. 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-K 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 2023, we reported a GAAP net loss of $18.7 million or negative $0.27 per diluted share. Distributable earnings this quarter were negative $26 million or negative $0.37 per share, including a write-off of $59 million or $0.85 per share. Distributable earnings prior to realized losses were $0.47 per share relative to our Q4 $0.43 per share dividend. Book value per share as of December 31, 2023 was $15.52, a decline of approximately 5% quarter-over-quarter. Our CECL allowance decreased to $3.06 per share from $3.21 per share last quarter. In mid-January, we paid a cash dividend of $0.43 per common share with respect to the fourth quarter. Additionally, the company’s Board of Directors declared a dividend of $0.25 per share of common stock with respect to the first quarter of 2024.

The divided is payable on April 15, 2024 to KREF’s common stockholders of record as of March 28, 2024. With that, I’d now like to turn the call over to Matt.

Matt Salem: Thank you, Jack. Good morning, everyone, and thank you for joining us today. Before turning to the current market environment, company results, and dividend commentary, I’d like to highlight KREF’s achievements during 2023. We have focused our efforts on maintaining high levels of liquidity, fortifying our liability structure, and proactively managing our portfolio, all of which has been critical to KREF’s ability to navigate this challenging market. To be specific, we have built and maintained a market-leading liquidity position with the help of KKR Capital Markets, with current cash on hand and undrawn corporate revolver capacity of nearly $600 million. Our financing continues to be best in class, which we further optimized by upsizing a repurchase agreement by $160 million, and extending the term.

KREF has no corporate debt or final facility maturities for two years. 76% of our secured financing as of year-end was completely non mark-to-market. And the remaining 24% is only mark-to-credit. We received $767 million of repayments, with office loans representing approximately 25% of total repayments. Our unfunded commitments as a percentage of the portfolio are 10% at year-end 2023, down from 16% at year-end 2022. More than half of our portfolio is supported by multifamily and industrial properties. Multifamily remains our largest property type representing approximately 41% of the portfolio. And we continue to see stable underlying performance across that segment with weighted average rent increases of 3.9% year-over-year in our portfolio.

Office represents our second largest property type, and since the beginning of last year has decreased as a percent of the portfolio, from 26% to 22% today, including a full payoff last month of a $173 million previously risk-rated 4 loan secured by a Washington, D.C. property. Access to KKR’s broader real estate platform with approximately 150 dedicated professionals and over $68 billion of assets under management has been instrumental in the management of KREF’s portfolio. Our capabilities have been further bolstered by our affiliated rated special servicer K-Star, with a team of more than 45 professionals and over $45 billion of special servicing rights, providing us with extensive expertise and access to sizable, real-time market information.

We have been actively using many tools at our disposal to execute on a variety of workout options, including modifications, restructurings, as well as taking title and managing real estate. Since our last fall, the Federal Reserve has indicated an end to their interest rate hikes, with potential rate cuts beginning in the first-half of the year. Market sentiment has improved dramatically as some of the tail-risks driven by inflation and higher interest rates have subsided. The broader rally in equities and fixed income is impacting the commercial real estate equity of debt markets as well, with significant heightening in CMBS and loan spreads over the past few months. The fear/greed factor has clearly shifted, and capital is flowing into the markets.

We expect acquisition and refinance activity to increase this year, and we are seeing that in our own lending pipeline across our different capital sources. However, despite the strong momentum, challenging remain given the value declines from the post-COVID interest rate environment. Today’s higher interest rates and carrying costs combined with interest rate cap costs and near-term maturity dates continue to stress real estate capital structures. And now, I’ll discuss KREF’s earnings power and dividend philosophy as we get into 2024. Last year, KREF’s earnings potential benefited from the higher interest rate environment, with average run rate distributable earnings before losses of $0.48 per quarter throughout 2023. We stated last quarter that 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 held in our risk rated five assets.

We have been proactive and transparent as we work through this market. And we have implemented a variety of strategies to optimize the outcome of our watch list loans. Today, we have a few assets where the best path forward to maximize value will be to take title, operate the real estate and stabilize cash flows before selling. Each has different circumstances, but this is high quality real estate that we have full confidence will lease and stabilize over time. To put it simply, we have great real estate, we have ample liquidity and we have the resources and expertise to create value. Once stabilized, we believe we can sell the real estate at a higher value than our current mark. We cycle that capital into cash flowing assets and return to a more normal level of operating earnings.

However, getting to stabilization will require time and impact earnings in the interim. To that end, the Board of Directors declared a dividend of $0.25 per share for the first quarter. The dividend is set at a level where we can cover with distributable earnings ex-losses with our performing loan portfolio under a number of different scenarios, including lower interest rates and the potential migration of loans to cost recovery and REO. To be clear, in the near-term, we expect DE ex-losses to be significantly higher than our dividend. Similar to how we’ve operated in the past, we are taking a proactive approach and making this adjustment now as opposed to waiting for a typical March declaration date in order to provide transparency. Importantly, as we sell our REO portfolio, we can reinvest the capital into new loan assets to unlock additional earnings potential.

To put some context around this, we believe we can generate an additional $0.12 per share and distributable earnings per quarter and this is just on our existing basis. Of course, the goal is to gain more than that over time. The assets driving this impact include our Portland Retail and Redevelopment Property, our Philadelphia REO, Mountain View projected REO and potentially the Seattle Life Science Loans which combined represent approximately $150 million of equity. Continuing with our transparent reporting, we’ve added a new page in our earnings presentation highlighting these assets. With that, I’ll turn the call over to Patrick.

Patrick Mattson: Thank you, Matt. Good morning, everyone. I’ll begin with updates to our CECL allowance and watch list. We finished the quarter with $213 million in CECL reserves, over two-thirds of which is held against the three, 5 rated loans. Reserves decreased by $9 million quarter-over-quarter primarily as a result of a few changes in Q4. First, upon taking title to the five-rated Philadelphia office asset we realized a $59 million loss, which is lower than the $69 million asset specific CECL reserve in the prior quarter. The CECL amount was reversed and realized loss flowed through our distributable earnings in Q4. Looking ahead, we are in discussions to sell two of the four properties in the near-term and do not expect any impact to DE as a result of the sale.

Second, we increased reserves on our loans secured by the Class A office campus in Mountain View, California, reflecting a lower valuation given the continued slow leasing environment in Silicon Valley and the lower levels of liquidity. We expect to take title to the asset in the second quarter. Third we downgraded the risk rating and increased reserves on a loan backed via Class A Seattle Life Sciences property. This property was built in 2021 and our sponsors purchased and converted the asset to life science lab use for spec lease up. As Matt mentioned, our multifamily portfolio has generally been stable, with low single-digit rental increases supporting NOI growth. Most sponsors have renewed interest rate caps and maturities. However, we downgraded two multifamily loans to risk ratings of 4 in the quarter given ongoing discussions regarding interest rate caps.

Both properties are over 90% occupied, and the loans are current on interest payments. As we continue to work through our watchlist portfolio we saw positive outcomes on two of our watches in D.C. office loans that had been on the watchlist last quarter. First, in January, the $173 million Washington, D.C. office loan paid off in full as the sponsor completed a refinance with a new lender. This recently renovated and well-located Class A office asset had leased up to nearly 90% following the completion of the sponsor’s CapEx plan. Our other watchlist Washington, D.C. office loan is now risk rated 3 following a modification finalized in the fourth quarter which included a $20 million principal paydown. The Class A property is 92% leased after positive momentum throughout last year.

With these positive outcomes, we have only one remaining risk rated 4 office loan. With current asset exposure in the form of a $37.5 million mezzanine loan secured by a Class A property located in Boston. Post quarter-end, we entered into discussions with the sponsor and have begun modification negotiations which may result in increased CECL reserves. We expect to provide a further update on the status of the modification next quarter. In the past 13 months, KREF has received over $1 billion of repayments, including two full repayments totaling approximately $325 million we received in January. Both loans were previously risk rated 4, including the D.C. office loan previously mentioned, and the New York City condo loan. The weighted average risk rating on the portfolio remain 3.2, and 87% of our portfolio is risk rated 3 or better.

KREF has built a diversified liability structure with $8.9 billion of financing capacity, and $2.8 billion of undrawn capacity. Our non-mark-to-market capacity remained substantial at 76%, and is diversified across two CER CLOs and a number of matched term lending agreements and asset-specific financing structures, as well as our corporate revolver. Excluding matched term secured financing, there were no corporate debt or final facility maturities until 2026. KREF is well-capitalized, with $136 million of cash, and $450 million of corporate revolver capacity available as of year-end, our best-in-class non-mark-to-market, and high levels of liquidity coupled with our deep relationships with both our financing partners and borrowers positions KREF strongly for this dynamic credit and interest rate environment.

Thank you for joining us today. Now, we’re happy to take your questions.

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Q&A Session

Operator: We will now begin our question-and-answer session. [Operator Instructions] And the first question will be from Sarah Barcomb from BTIG. Please go ahead.

Sarah Barcomb: Hey, good morning, everyone. So, I think a good place to start would be with this dividend cut, obviously a big reset here. You mentioned in your prepared remarks that it was mostly the earnings drag from REO assets and non-performing loans that really drove this decision to cut. I’m also wondering how much of the dividend cut can be attributed to the near-term risk of multifamily loan maturities that are coming up this year? We saw a couple multifamily assets come on the watchlist [this print] (ph). You spoke to those dynamics in your prepared remarks, but we’ve talked a lot about this risk in recent quarters, these 2021 vintage loans still have SOFR capped well below today’s levels, and a significant portion of those caps should come off this year.

So, when you were thinking about this dividend reset, how much did that dynamic come into play just thinking about multifamily debt service coverage and maybe the risk seeing more sponsors push back on re-upping that rate cap, was hoping you could speak to that a little bit?

Matt Salem: Hi, Sarah, it’s Matt, and happy to take it, and thank you for the question. I guess when we think about the multifamily portfolio, I don’t think our view has changed that much from what we saw or what we spoke about last quarter. As you highlight, obviously leverage has come up in those loans just given the change in cap rates and interest rate environment. Keep in mind, our portfolio is almost all Class A multis, so this is pretty high quality real estate. We’ve got — I think we’ve always been pretty transparent in terms of just how we’re identifying our risk ratings and those particular loans that you mentioned that moved into the 4-rated bucket this quarter were obviously in modification discussions, but loans are current.

So, we’re going to see where we ultimately end up there. But it comes back, I think, to our high-level view, which is there’s going to be probably noise in the multifamily sector just given that change in value. But it really comes back to value at the end of the day. And whereas we think about projecting what’s going to happen in our multifamily portfolio, we’re not expecting a lot of losses at all. I think there’s a — in most cases we’ll be able to work with our borrowers. Where you’re seeing the most stress is in borrowers that have a little bit less liquidity, and so that interest rate cap becomes more problematic. The one thing I would highlight as well in the multifamily sector is the amount of liquidity there is tremendous. And when you think about the macro environment, where we are today, with a better understanding of interest rates, inflation, et cetera, we’ve seen a pretty strong demand for multifamily assets as we look across SOFR equity and our credit business.

So, a longwinded answer to your question, but we’re not really anticipating that much trouble within the multifamily portfolio, but there’ll be a little bit of noise here and there.

Sarah Barcomb: Okay, thanks for the color there. And then my follow-up is more office life science related. We were happy to see the good news updates on those two D.C. offices. And from a headline basis, there was no strictly office watchlist migrations. We did however see that Seattle life science go straight from a risk 3 to a risk 5. So, was hoping you could speak a bit more as to how we should be thinking about the rest of your life science exposure, especially for properties that were potentially originally purposed for more traditional office use and then pivoted to the life science format, like we saw with the Seattle asset, just hoping you can speak to the rest of the life science portfolio and how we should be thinking about those properties as offices or as leasable life science? And that’s it from me.

Matt Salem: Sure, happy to do it. A couple things I just want to highlight, and maybe this is the best place to address it. We have a lot going on in the portfolio this quarter, but if you take a step back and you think about our management team, our posture in the market, and from where we’re sitting, it feels like we’re getting through most of the major issues, right? We’ve dealt with — we’ve modified loans, we’ve restructured loans, we’re going to go to title on a couple of these assets. These bigger office — bigger for the office portfolio, where we felt like we would have issues, like we’re largely through that. We’ve got one more 4-rated office loan, that Patrick highlighted on his comments, that we’re in negotiations on with a modification, and that will likely lead to some increase in reserves.

But as we’ve talked about in the past, the rest of the office portfolio, we still feel good that we don’t see any near-term intermediate-term migration of that portfolio into higher risk ratings. So, we’ve come a log way, and the market’s come a long way. This time last year, we didn’t know where inflation was going to be, we didn’t know when the Fed was going to stop hiking, in fact we had like four more hikes ahead of us. And now, clearly, we’re in a much different environment and we’re debating how many and when interest rate cuts are going to start. So, the market has changed a lot. We’ve worked through our portfolio a lot. And overall, we feel like we’re in a much better position today than a year ago with all that uncertainty. As it relates to life science, we break it down into a couple of different buckets within our own portfolio.

But a little less than half of our portfolio is basically construction. So, it’s purpose-built, very well-located, trophy-like real estate within the life science sector. We feel very good about that component of the portfolio for those reasons. We do have some that was more of a conversion from office, traditional office, to life science. Those have been converted at this point in time, so don’t think about those as traditional office. Those are ready for lab leasing, including our Seattle transaction or property. And a big subset of those, have leasing in place, and I think one of the reasons we saw the jump in the risk rating in the Seattle life science, it’s a big business plan, right? There’s a big lease up ahead of us there. And when you add that together with the time that takes and the cost of carry in the market, it just gets really expensive for the existing sponsor.

So, we’ll continue negotiating that with our existing sponsor there. We don’t know exactly which way that’s going to go yet. Obviously, we reference it as a potential REO, but we could get to a modification there as well. We’ll see how that discussion plays out. And that’s a little bit how we’re thinking about the overall life science portfolio. So, by the way, still a sector we like a lot. We think obviously we’ve had a little bit of cyclicality as it relates to the equity markets but with where we are today and liquidity returning to the sector, I think we still feel very good about the intermediate and long-term prospects of the life science business.

Sarah Barcomb: Great. Thank you.

Operator: And the next question is from Don Fandetti from Wells Fargo. Please go ahead.

Don Fandetti: Can you talk a little bit more about the sort of difference between your expectations for DE and the $0.25 quarterly dividend? And sounds like you ran some scenarios. What would it take to put you at that tougher end of that scenario where DE gets closer to the $0.25?

Matt Salem: Yes, Don, it’s Matt again. I can take that question. I think the two big factors that could drive that lower, which is probably obvious, but portfolio performance. So, if we saw continued negative migration in the portfolio, non-performing loans, REO, et cetera, beyond anything that we’re seeing today, obviously we’re incorporating our current views of, for instance, the Boston office four-rated loan. Of course, that’s incorporated in what we’re projecting currently, but if it goes beyond kind of our current expectations, that could impact DE and bring that number closer down to that dividend level. And then, just interest rate cuts, right? We can all look at the forward curve. We’re running a number of scenarios beyond that.

But if we got into some type of like major cutting by the Fed, that will put pressure on the portfolio as well. But we’re trying to look out a fair amount of quarters here to make sure that we’ve got some headroom and gives us time, right? We want to have patience. We want to protect book value to work out these REO assets. I think it’s what our shareholders really want us to do is use our expertise and as part of a bigger KKR ecosystem. And so, we are trying to buy a fair amount of time to be able to effectuate those business plans.

Don Fandetti: Got it. And then, the comments on office are interesting. It sounds like you’re not expecting any intermediate-term migration on the risk ratings other than the 1-4 rated. What kind of gives you that confidence, just given it seems like there’s still a lot of stress in the office, plus you have rate caps and other dynamics?