KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q3 2023 Earnings Call Transcript

KKR Real Estate Finance Trust Inc. (NYSE:KREF) Q3 2023 Earnings Call Transcript October 24, 2023

Operator: 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. [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 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.

Matt Salem: 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 created 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-market 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 mark 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 and 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 on 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.

Patrick Mattson: 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 to 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 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 complete 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 of 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 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 are 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 as 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 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 match 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 positioned 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.

Operator: [Operator Instructions] Today’s first question comes from Sarah Barcomb with BTIG. Please go ahead.

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Q&A Session

Sarah Barcomb: 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 are 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.

Matt Salem: Thanks, Sarah. It’s Matt. I appreciate the question and you joining us today. Yes. I mean, obviously, there’s a number of assumptions that are going into that, one of which is cap. There’s 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 kind of all those different inputs at this point in time.

Sarah Barcomb: 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.

Matt Salem: I think there’s 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 offense defense perspective, I still think we’re in the 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, 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’s clearly some capital sources out of the market, namely U.S. domicile banks. So, I think that’s to the extent we turned on KREF, we’d be pursuing some of those same type of themes into next year.