KKR Real Estate Finance Trust Inc (KREF) 2020 Q3 法說會逐字稿

Good morning, and welcome to the KKR Real Estate Finance Trust Inc. Third Quarter 2020 Financial Results Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Michael Shapiro. Please go ahead.

Thank you. Welcome to the KKR Real Estate Finance Trust earnings call for the third quarter of 2020. We hope that all of you and your families are continuing to stay safe and healthy. Today, I am joined on the phone by our CEO, Matt Salem; our President and COO, Patrick Mattson; and our CFO, Mostafa Nagaty.

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-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 third quarter, we had a record GAAP net income of $31.4 million or $0.56 per share, which included a $0.1 million benefit from a lower CECL provision. Core earnings this quarter were $32.5 million or $0.58 per share, driven by the continued strong performance of our portfolio and is significantly in the money LIBOR floors.

One change to note. As per SEC guidance, beginning with our fourth quarter results in early 2021, we will begin reporting core earnings inclusive of the change in the CECL provisions. Consequently, we will recast prior quarter's results to reflect the change in presentation. Please note that had we adopted the aforementioned change in presentation, core earnings per share this quarter would have benefited by $0.01 and been $0.59 per share.

Book value per share as of September 30, 2020, increased to $18.73, which included the impact of $1.16 per share from CECL as compared to $18.57 as of June 30. Finally, I would note that in mid-October, we paid a cash dividend of $0.43 per share with respect to the third quarter.

With that, I would now like to turn the call over to Matt.

Thank you, Michael. Good morning, and thank you for joining us today. We hope you are all healthy and safe.

We had a strong quarter on many fronts. We continued to see the benefits of our company's conservative positioning on both our lending strategy and liability management, which has allowed us to differentiate ourselves during this volatile market.

Since the onset of COVID, we have maintained: A best-in-class portfolio, comprised of $5 billion of lighter transitional floating rate senior loans, with a significant overweight to multifamily and office properties, and only 8% exposed to hospitality and retail; increased our market-leading fully non-mark-to-market financing to 78% in order to further de-risk our liability set; increased our liquidity position through the inaugural issuance of a $300 million Term Loan B, which enables us to take advantage of the current lender-friendly market, all while delivering record quarterly earnings, which has benefited from net interest margin expansion resulting from our strategically negotiated in-the-money LIBOR floors.

As of September 30, our portfolio balance was approximately $5 billion, with only $462 million or 9% of total commitments for future funding obligations. Our almost exclusive senior loan portfolio focuses on institutional real estate and sponsorship, and is secured predominantly by Class A lighter transitional multifamily and office properties in the most liquid real estate markets. Our average loan size is $135 million, and approximately 80% of our loans are secured by properties located in the top 10 markets in the United States.

Our investment portfolio is 99% senior loans with no direct holdings or securities. As I mentioned, our 2 largest property type exposures are multifamily and office, which represent 83% of the portfolio collectively and have a weighted average occupancy in the mid-70s. In addition, 86% of our multifamily loans and 75% of our office loans are secured by Class A properties.

Underlying tenant collections have been consistently high. As a reminder, none of our office properties are located in New York, San Francisco or Los Angeles, markets which have seen significant increases to co-working tenants in recent years.

Over 99% of our collections are current through October. Through our robust quarterly asset review process, we reevaluate every loan in the portfolio to assign an updated risk rating. Our portfolio has a weighted average risk rating of 3.1 on a 5-point scale, consistent with the weighted average risk rating at June 30. 84% of the portfolio was risk-weighted 3 or better, and we feel confident about the performance of those -- on those properties. We don't anticipate much transition in our ratings in the near term.

As we did in the second quarter, we provided a detailed breakout of our watch list loans in our supplemental presentation. We feel good about our position in many of these properties and are seeing improving trends in a number of business plans.

However, we haven't been completely unimpacted. As we have previewed prior, our Portland retail property is most negatively exposed and was downgraded from a 4 rating to a 5 rating this quarter. While this loan is current as of October, we expect to be entering discussions given the pending maturity. We believe we have adequately reserved against any potential impacts from this loan through the CECL evaluation process.

For the second straight quarter, we are beginning to see some signs of normalcy in the broader market, both from an origination and repayment perspective. Starting with repayments, during the quarter, we received approximately $274 million of repayments, including an approximately $30 million paydown on one of our New York condo inventory loans.

Subsequent to quarter end, we received an additional $65 million of repayments.

It is always difficult to accurately predict repayments and even more so in this market environment. But as a reminder, we have several loans in our portfolio near or at stabilization.

On the origination side, while we didn't close any new loans prior to quarter end, we did close 3 transactions in October. With many lenders on the sidelines, we were seeing a favorable market dynamic, resulting in better credits and opportunities to create net interest margins in the mid- to high-100s, as compared to the low-100s earlier this year, pre-COVID.

Let me spend a couple of minutes providing incremental details on our recently closed deals. All 3 are good examples of our return to market and continued focus on the same high-quality real estate we have been underwriting since our IPO.

Additionally, they highlight the benefits KREF receives from being part of a leading global alternative asset manager and a growing real estate platform. As you may have noted, KREF co-originated these transactions with other KKR private strategies.

KREF is our flagship transitional senior loan strategy and has priority over these investments. But at times, where it makes sense, we will share risk depending on factors, such as the timing of commitment, the loan size and KREF's liquidity position.

The first 2 examples are similar to the loans we were making pre-COVID, refinancing newly-delivered luxury Class A multifamily buildings and markets with strong underlying demographics. Our loan provides our sponsors a better cost of capital in time to lease the property and burn off the initial lease-up concessions. Both properties have commenced leasing, and there were no moving pieces as it relates to construction.

We were able to underwrite recently signed leases and extrapolate into a stabilized cash flow, leading to a straightforward underwriting on a simple business plan.

In a notable transaction, KREF co-originated a $509 million whole loan, with KREF committing $160 million to a leading real estate development company in the San Francisco Bay Area to acquire and renovate a 1 million square foot Class A office in Oakland, California. We were executing a senior loan sale of approximately $135 million to finance our retained $25 million piece. This financing is a great example of the benefits of having access to a broader asset management platform, utilizing the full KKR brain to lend on high-quality, well-located real estates.

The best examples of this are, from a sourcing perspective, it was an institutional sponsor that was an existing JV operator for our real estate equity team. From an underwriting perspective, effectively, single-tenant asset that our corporate credit team was already familiar with and an underwritten, and we had local market knowledge, for KKR Real Estate owns office properties.

Finally, from an execution perspective, we worked closely with our capital markets team to speak for the whole $509 million while having line of sight on the sale of the senior portion to generate an attractive return. Our forward pipeline remains strong with several loans under exclusivity, which are expected to close within the next few months.

You will continue to see us focused on investing in defensive property types, in liquid markets and with top-tier sponsors, while maintaining our focus on capital preservation. Sitting within the broader KKR platform gives us a unique perspective and a look into risk-adjusted returns across asset classes. The combination of KREF's in-place portfolio, our cost of liabilities and the additional new loans underwritten in today's environment, we believe are delivering attractive risk-adjusted returns relative to other yield proxies.

We are excited about our franchise, in our competitive positioning in the market and the continued growth opportunities for KREF for the remainder of 2020 and going into 2021.

Now let me turn the call over to Patrick.

Thank you, Matt. Good morning, everyone. I hope that you continue to stay safe and healthy.

As of quarter end, a market-leading 78% of our in-place asset financing was completely non-mark-to-market, and the 22% remaining balance was only subject to credit marks. We continue to invest a considerable amount of time and resources across KKR, differentiate and diversify our financing sources, and in September, we were excited to close our inaugural Term Loan B issuance.

The proceeds from the $300 million 7-year loan allow us to take advantage of the current lending opportunity, as well as continue to reduce some of our mark-to-credit facilities. Additionally, the pricing flexibility of the Term Loan B affords us the ability to adjust the cost of capital in the future to match the conservatively positioned profile of our assets and other liabilities.

Our intense focus on non-mark-to-market financing has allowed us to lower the risk of our liabilities, while at the same time, maintain target leverage levels despite the volatility this year. As of quarter end, our debt-to-equity ratio and total leverage ratio were 1.9x and 3.8x, respectively, down from the second quarter. As a reminder, we had generally targeted a 3 to 4x leverage ratio on new senior loans, depending on the source of financing.

While we've been willing to finance loans at a low-80s advance rate on our non-mark-to-market financings, we would expect our total leverage ratio to gravitate more toward the mid-3s in the coming quarters. Our repo financing, which currently represents only 22% of our outstanding secured financing, is diversified across 3 banks, and currently has a weighted average advance rate of approximately 65%. The repo facilities financed 10 loans, predominantly secured by Class A multifamily and office assets. Notably, we have not received any margin calls on these mark-to-credit facilities.

KREF's liquidity position remains very strong with over $700 million of availability, including cash of approximately $300 million as of 3Q and access to an additional $335 million on our corporate revolver. While we have currently earmarked some of our liquidity for our increasing pipeline of loan opportunities, given the level of uncertainty in the markets, we do expect to hold incremental cash on the balance sheet versus prior years to maintain flexibility for the foreseeable future, which could create some incremental drag on earnings.

Additionally, as we started to see in the third quarter, a higher rate of repayments and timeliness match between repayments and new originations may add to our liquidity position in the near term.

Finally, almost the entirety of the portfolio remains invested in LIBOR-based floating rate loans. 98% of the loan portfolio has a LIBOR floor of at least 95 basis points, while only 2% of our liabilities, excluding the new Term Loan B, have a LIBOR floor above 0. So with spot LIBOR averaging 16 basis points for the third quarter, our rate floors were almost entirely optimized for the full quarter, providing a significant earnings benefit.

For further context on the benefit, since the beginning of 2020, 1-month LIBOR has decreased 160 basis points. During this same period, bolstered by our rate floors, our loan coupons have only decreased 20 basis points from 5% to 4.8%. At the same time, the decrease in LIBOR has dramatically reduced our liability cost, resulting in an expansion of our effective net interest margin by 130 basis points to a level above 280 basis points on our direct secured borrowings.

As we experience a rotation in our portfolio through loan repayments and new originations, we expect NIM to compress over time.

In summary, our best-in-class investment portfolio is providing strong earnings power through loan performance and significant in-the-money rate floors. We generated record net income during the quarter. We continued to diversify our financing sources, including growing our market-leading 78% non-mark-to-market secured liabilities with the issuance of the new 7-year Term Loan B.

We have a very strong liquidity position, allowing us to return to the new originations market, lending at attractive levels on credits consistent with our historic underwriting.

Thank you again for joining us this morning. And now we are happy to take your questions.

(Operator Instructions)

The first question today comes from Jade Rahmani of KBW.

Can you give some color as to the types of deals you're seeing? And what the sponsors are looking to achieve? If there's been any changes in the way they're underwriting deals? I noticed one of the deals had below a 50% LTV. Just some color on the transaction market.

Jade, it's Matt. Thanks for joining, and good to hear you. Yes, as a little bit of color, we're seeing the markets slowly reboot here. And obviously, we're starting to take advantage of that. I would say, all-in coupons are in the 4% to 4.5% range for the higher quality assets. And there's real bifurcation, I would say, in the market today between the have and the have nots. So clearly, you can understand hotels and other sectors that have been the most impacted. The financing there is much more difficult and coupon is much wider there.

Where we're focused is -- where we've been focused historically, so I don't think we've really changed our credit DNA at all. So really trying to focus on the multifamily sector of the market and then well-leased office. What's a little bit different now is two things. One, it's more of a lender's market as you would expect. So you get better structure, better credit, in some cases, lower leverage. Obviously, the all-in coupon, similar to what we were lending at pre-COVID, but the composition has changed quite dramatically given where LIBOR is. So the spread is very high. And the overall NIM, as we mentioned on the call, has increased from low-100s to very high-100s.

And the other thing I would say is that the fact pattern or the business plan that you're lending on is a little bit more advanced. And so, for instance, if we were making a multifamily loan pre-COVID on a construction takeout lease-up, that property may have been somewhere between 10% and 30% occupied. So some of the opportunities we're seeing today are more 50% occupied or higher. And clearly, there's going to be a range.

But what the sponsors need is just more time, right? Everyone's trying to buy time. And so I think that the traditional segment of the market will continue to have a lot of opportunities to lend as sponsors just need to -- they need to -- their business plans are all elongating, whether that's any type of lease-up and so they're just going to need to buy that time and get a new financing that allows them to effectuate that business plan.

Turning to the office sector, are you seeing any broader changes in the way either sponsors, lenders or the market overall is looking at office space? I think that pre-COVID, the average office lease was somewhere in the 8.5 to 10-year range, and there is some chatter about typical lease durations being curtailed. JLL's CEO said that in the second quarter, the average lease deal had 16% shorter term. How are you thinking about that or what are you seeing with respect to the office market?

Yes. Well, I think everyone puts office in this category of -- it has a big question mark around it. And in my mind, is a real cyclical issue with office. I mean you never want to lease-up office in an economic downturn. And then there's the secular question that we're all debating around usage going forward, changes in behavior. So I would say, given those are both at play, both kind of the secular and the cyclical, I think we're very cautious right now on the sector overall. We don't have enough data points to answer your question directly if our lease is getting shorter. I would say, as we're underwriting new office loans, we want higher occupancy, longer leases, more stability, and we're still taking a lender's view and protecting our downside.

So -- but I don't think the market's evolved enough to really tell you this is exactly what we're seeing in terms of shorter lease terms. It certainly wouldn't surprise me. But again, I'm not sure that's a secular issue or a cyclical issue.

Okay. Turning to the Portland asset, you said that you feel adequately reserved with respect to your basis and the CECL reserve. What are you looking at the outcome and a workout? Is this going to be essentially a foreclosure, whereby KREF takes control of this asset and figures out a repositioning strategy?

Would you bring in third-party capital for this? And just directly, what impact will this have on the company's liquidity is? I believe this asset is not financed any repo line, so it probably will have a minimal impact on liquidity. But if you can just touch on that.

Sure. I think it's too early to tell on how exactly the workout proceeds. We have a sponsor in place still that's kept our loan current. And so we'll be working with them on what the business plan is going forward. And I think it's too early to speculate how this may play out.

Patrick, I'll turn it over to you for the liquidity perspective. But overall, it's not a big position, obviously, for us, and we have as much liquidity as we've had in the company. But Patrick, do you want to give any specifics?

Sure. Jade, just to follow-up on that. So we've got a small amount of leverage against this, something on the order of less than 20% of the face amount of the loan. So not a big mover in terms of our liquidity usage, if we decide to pay off that financing.

Next question comes from Don Fandetti of Wells Fargo.

So look, I mean, it's good to see you guys holding your own in a difficult market. I was wondering, Matt, if you could just provide an update on some of the other watch list assets, in particular, the New York condos, and then the Fort Lauderdale hotel.

Don, it's Patrick. Let me start with that one. So just first on the New York condo hotel. This is an asset that over the last couple of quarters, we've actually seen an increase in sales. So both in the second, in the third quarter, we saw 3 units sell in each of those quarters. And there's an additional unit that sold and closed here in the fourth quarter, which will get reflected when we report next quarter.

I think we've been pleased with the progress of the paydown. Those sales for context have been in the $2,200 foot range. And for context, our loan is around $1,720 square foot. And so from a basis standpoint, we feel good. We like the velocity against -- on those sales. And the amount of leverage that we have, similar to our Lloyd asset is really a fraction of our outstanding loan balance. So in total, we've had about $41 million of paydowns these last 2 quarters.

On the asset in Florida, we continue to work closely with the sponsor. As you recall, this is an asset where we've entered into a partial forbearance on the payment in exchange for some cash that came in from the sponsor. That partial forbearance period extends for several more months. And we've seen some improvement in terms of the occupancy of that asset, but it remains challenged in terms of the pre-COVID level. So one that we continue to sort of monitor, but one where we've got a path to continue to work with the sponsor and help them really sort of manage through the situation.

Got it. And how would you describe the overall commercial real estate lending markets from a stress perspective? I know there's a lot of concern. Could you just talk about it from a high-level?

Sure, Don. It's Matt. I can jump in there. I guess a couple of things. One, it's -- I think it's lagging the more liquid markets. And so it's certainly -- we haven't seen anywhere near the level of yield compression that you see in the corporate credit market or the securitized markets. There's clearly a lag in the private markets or specifically in CRE lending.

There's a bifurcation, like I mentioned before, between the have and the have nots, right? And that's really by property type for the most part, to some extent, business plan and the transitional pending segment, but predominantly property type. And so there's definitely a whole swath of retail assets and hotel assets that just don't have access to financing today or it's extremely expensive.

And then, as it relates to the business plans, as you could imagine, the more transitional you get, the heavier the lift is, it's going to be tougher to finance right now. And again, that's -- we're in unprecedented market, and I think people are cautious right now. And so you can understand the conservatism on the lending front with those assets.

And then I would just say in terms of the participants in the market, what we're seeing, at least in our space is, there's definitely less competition, which is making it attractive and perhaps why we're lagging here. But there's capital out there. I wouldn't call the market distressed. And we're lending at 4% to 4.5% coupons. I think that's attractive, but I don't think it's distressed.

And you do see a number of participants in the market, as you would expect. The securitized lenders are back with CMBS product, both on large loans as well as on conduit. Insurance companies are very active. I would say one of the sectors where we haven't seen as much activity are the big money center banks and so that's one area that we're watching closely.

Next question comes from Stephen Laws of Raymond James.

I guess, first, I want to ask about the LTVs on the new originations. I noticed 2 were refinances. So you would have done a new valuation analysis on October. Can you talk about how much the value declined on those 2 appraised value declined on those 2 assets from the loan they were refinancing, which I would have -- and I assume that, that valuation was done pre-COVID. And please let me know if that's not the case.

Yes. Thanks for the question. I don't think I have the exact answer in terms of like the appraisals lined up from their pre-COVID into what we're doing today. I will tell you, on the multifamily assets, we're generally -- on the lease-up multifamily assets, we're generally underwriting down, call it, 10% to 15% area in value, just because it's taking longer to lease-up, and there's clearly a concession package involved in today's market.

So it's really the cash flows that are changing the valuation. As you would expect in this kind of interest rate market, we do -- we are seeing, and we expect to see more cap rate compression once the assets have stabilized. But it's taking longer to get there in our underwriting.

Okay. And then shifting over to the change in core and then coupled with that, an outlook on the dividend. Kind of believe CECL is a noncash item, the CECL reserves. So I would love kind of a little more background on your thoughts to now include that, see noncash CECL change in the core metric, especially with some of the inputs that go into that being macro and not company-specific. Additionally, I think historically, we've used core earnings as a proxy for the dividend, but I don't believe that CECL is something that impacts retaxable income, which determines the dividend distribution.

So can you talk about going forward after this change, what we should look at as a proxy? Should we simply take your core earnings and back out CECL, the way it's been done? And to that point, any spillover income from last year, any income you can spill forward that we need to think about with regards to satisfying the 90% distribution requirement for this year?

Stephen, thanks for the question. This is Mostafa, so I'll take that one. So just to clarify that the change in the core earnings presentation prospectively is a result of an SEC come that we received directing us to no longer exclude the provision of credit losses or a portion of the provision for credit losses from our core earnings presentation going forward. And we intend -- we noted that in our MD&A and also, as noted by Michael in his prepared remarks.

So what is meant that change is starting with Q4 and all subsequent quarantined periods. And obviously, for consistency, we will recast our core earnings presentation for the first 3 quarters to correspond with the new presentation.

That said, we don't believe that, that change -- that this is just a change in the presentation of core earnings for reporting purposes. And obviously, the CECL provision will continue to be reported as a single line item on our income statement, so anybody can do the math there.

With respect to the coverage from a dividend standpoint, I think the old presentation of core earnings would be a good proxy. And we believe that we will meet the distribution requirement from a dividend standpoint, for this year.

Our next question comes from Charlie Arestia of JPMorgan.

A bit of a follow-up on the CECL there. Look, I think there's no better demonstration of kind of a more incrementally positive economic outlook than putting money back to work. In that context, should we see some tweaking of that CECL reserve going forward? And just how are you guys thinking about the overall reserve rate on the portfolio?

Yes. This is Mostafa again. So I think it's a good question. With respect to the reserve, I think, obviously, the reserve fluctuate quarter-over-quarter depending on a variety of factors, including, obviously, our originations volume, our repayments, velocity and also changes to the macro on top of that. But generally speaking, everything else equal, we would expect the biggest driver for that change and the CECL reserves would be resolution of any of the watch list loans or the 4 and 5 rated loans and also the macro outlook over the next few quarters. So those will be the 2 key drivers.

Okay. Got it. And then just a unrelated follow-up, I know there was some deferred interest discussions on, I think, the Portland loan, but I'm just wondering if there were any other additional loan modifications that were kind of executed during the quarter.

Charlie, it's Patrick. So in terms of the quarter, we obviously had the 2 hotel loans where we had modifications in place. There was one other modification related to interest payments, which is on the New York condo loan, which I talked about earlier. And there, we entered into a partial forbearance on a portion of the interest payments. There was a little bit of paydown associated with that. But that's it in terms of interest related modifications in the quarter.

This concludes our question-and-answer session. I would like to turn the conference back over to Michael Shapiro for any closing remarks.

Thank you, everybody, for joining us today. We hope you stay safe, stay healthy. And if there's any follow-up questions, please feel free to reach out to any of us. Thank you again.

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