KKR Real Estate Finance Trust Inc. (KREF) Earnings Call Transcript & Summary

To have with us 2 mortgage REITs, 2 leading mortgage REITS, TPG Real Estate Finance Trust. We have the CEO and President...

[indiscernible]

I guess I jumped the gun. We got the CEO and President, Greta Guggenheim; and then also from KKR Real Estate Finance Trust, we have Matt Salem, who's also co-CEO and Co-President. For those in the room or on the webcast, you can sign into liveqa.com and enter code Citi2020 to submit any questions or you can just raise your hand if you're in the room.

So I think that we could just start off. Each of you can maybe give us just a quick summary of how you view the market today. And I know it's kind of tough with the last couple of weeks of volatility that we've had. But just in general, just describe what your focus is and how you're planning to maneuver over the next 12 months. You start, Greta.

Sure. So we focus on first mortgage loans. We are -- our balance sheet is 100% first mortgage loans with a weighted average LTV of 65%, and it's 100% performing. And we focus on cash flowing assets that will be stabilized within 24 months and assets in the top 10 markets with institutional borrowers. I would say, in terms of the market for loans, pre-coronavirus, I would say it was pretty consistent with last year. I would call it pretty good, very favorable in many ways, other than the spread compression. But there is a lot of liquidity. We were seeing really strong deal flow. We increased our earning assets by 32% last year because of the deal flow. And at the end of -- on our earnings call, we announced that we had a pretty strong pipeline of over $800 million subsequent to quarter end. So it felt really good. What the coronavirus does, I can't really say. It really began -- we began to feel it starting Wednesday and Thursday and Friday of last week. And in the debt capital markets in our space, credit spreads have been pretty good. They haven't blown out as much as we've seen on the corporate side. I believe a conduit deal priced today, and I heard that the AAAs were 15 basis points wide now on a 10-year fixed rate deal, that's 1.5 points for the issuer of profit loss with 15 basis points widening, but it's still not a crazy widening. I haven't heard what happened to the BBBs, I'm sure they're out wider. And on the -- on calls that we made on Friday, we were told that among all the debt capital markets, whether it's CLO or CMBS and Term Loan B, that everything is out about 15 to 25 basis points with the BBBs out maybe 40 to 50. So that's my update.

That's helpful color. Matt, can you just give us a little [ update ]?

Absolutely. Thanks for the time today. Matt Salem, I represent KKR Real Estate Finance Trust. We, as well, are a first mortgage lender. We currently have a little over a $5 billion portfolio of first mortgage loans. We focus on larger loans. Our average loan size last year was around $175 million, predominantly in the larger markets. So if you look at our exposure, about over 75% of our loans are in the top 10 markets and over 90% are in the top 30 markets, so really in higher quality markets. We try to lend to people like ourselves. And so high-quality sponsors, institutional owners and managers of real estate that we think have the -- both operating expertise and the financial wherewithal to implement their business plan and to, obviously, withstand volatility in markets. So it's a relatively, I think, simple business and portfolio to understand. Year-over-year, again, before the most recent bout of volatility from the virus, I think the market was largely the same. I think we saw a little bit of spread compression on the asset side. However, the demand for our liabilities was pretty high as well. And so I think we offset most of that spread compression through tighter liabilities. The pipelines over the last few years have been robust. We originated $3.1 billion of mortgages last year. And I think we can -- we'll continue to see that. I would say the mortgage REITs have a very efficient and effective cost of capital. We tend to take more and more market share each year. And so I would expect us, as a group, to continue to have success on the origination front.

The -- I think what comes through both in both of your comments are the strength of originations. And we've seen that across the industry. What necessarily is driving that? Do you think that the industry in each of your firms are able to take, I don't know if it's a larger share of the overall industry or there's additional credit to be lent out? Maybe just discuss the dynamics there. Start with Greta.

Well, I think part of the reason the pipeline has been robust and our origination bonds have been strong is that our typical clients are, like us, private equity-type sponsors, institutional sponsors, and they have raised record amounts of money. It's -- and their dry powder is very large, and they're on track to raise significant amounts of capital this year. And so they've been very active in the value creation, value-add space. That's where they -- many of them see the most value. And that fits perfectly for our type of loans, which are transitional assets. So we've seen a lot of significant acquisition volume from that sector. And I think that's 1 factor. I believe that they come to us because of the -- as opposed to, say, a commercial bank, because of the flexibility and the speed with which we can operate. And just -- and also, so that they're dealing with folks like us when they have asset management issues that come up. And on transitional loans, things always come up. And you need to be able to speak to your lender and not some servicer in a remote office to work through whatever it is that has come up.

Yes, I agree with Greta. Like the flexibility is really important. Obviously, the transaction volumes have been high and the capital raised. So I think that's all been fueling some of the growth. I also just think that if you look at the competitive set, we've got a pretty broad range of spread or products to offer, like we're predominantly all first mortgage lenders, but we all have a little bit different DNA in terms of what we like to do. And we -- basically, the group, as a whole, will originate loans somewhere between LIBOR plus 2.25 to LIBOR plus 4.50. So that's a pretty big range of offering in terms of different risk-reward profile that the market compares. So I think part of it is just that we've got really effective capital, and I think it has a wide range of what it can target.

Maybe you could discuss what the banks or the -- your business doesn't compete directly with banks for the most part. What dynamics of your loans and how they differ from bank financing?

I mean I think -- I would agree. We don't really compete with banks. I think most of it is due to cash flow, which can be translated into occupancy for the most part. So if you think about, like our portfolio today is 84% office and multifamily. We have almost 60% of our portfolio is in multifamily loans. And so how do we compete there versus agencies or versus banks or insurance companies that obviously like to win on the multifamily asset class as well is that we'll do a lot of like construction take out loans. So we don't do the construction part. We wait until it's built and have the TCO. The property is probably 20% to 30% leased. So we have some real renters that we can extrapolate where the rental level is and per unit, and so we can help -- that helps inform our underwriting. But we're coming in before it's obviously stabilized without a stabilized cash flow, and we're giving that owner time to lease it up, one; and then number two, typically burn off concessions because concessions are generally higher on a full lease-up play. So that's an area, I think, is a good example of like -- banks don't play in that area at all. It's low cash flowing asset or no cash flow asset to the bottom line, but we think it's really safe. There's a short-term business plan that a sponsor has got to implement. This property is built and they've got -- just got to deliver on the leasing execution. But that's a good example of like why a bank wouldn't necessarily play there.

Greta, if you have that same experience?

Yes. No, I agree with that. Maybe we provide a little bit more leverage. We see the banks cap out on other property types, not necessarily multifamily, it's sort of 60%, 65%. And we're willing to go to 70% or higher in certain select asset types, like multifamily, and we're not seeing the banks there as much. They've certainly pushed up in the last year or 2, but I don't think they've kept up with the nonbanks or caught up with them.

Greta, that's a good point. Maybe we can segue into competition. How would you characterize competition today versus a year ago? And are you seeing any irrational behavior from folks in the industry?

I would say the competition is -- was intense last year and it's intense this year. So that hasn't changed. Irrational behavior, I mean, we do lose deals for terms that we're unwilling to provide. I don't think it's like 1 actor each time. I don't think we're losing to the same group. I think it's just there's always an outlier. And the mortgage brokers are going to go with that outlier, if they can, if they think they're reliable and will close. But it's not been as -- having been an active lender for many decades, I don't think we're seeing any wholesale crazy behavior among lenders like we did right before the financial crisis, as an example.

And so when you say that there's folks that you might lose out to, is it typically on price? Or is it structuring? How -- what's...

It could be certainly price. But usually, it's on structure, proceeds, structure, reserves. I know there is a deal that we quoted recently, and we wanted a full cash flow suite from day 1, and they're finding someone who will do it without a cash flow suite from day 1.

Maybe we could touch a little bit on CECL. CECL was adopted by the industry. There was pretty modest impacts, kind of ranging from like 11 to 30 basis points of allowance. Are you seeing any change to the underwriting as people look at return hurdles under a new GAAP environment? Maybe, Matt, you could touch on that.

I would say no. I don't think anyone is going to change the way they operate based on CECL or GAAP kind of accounting measure. It's somewhat theoretical in our space. I think over the long term, it will be helpful for investors. But right now, it's very theoretical, and you're using models and historical data that doesn't really represent your loan portfolio very well, but you do the best you can. And that's how we've calculated our numbers. But we certainly wouldn't change the way we're lending or our posture in the market because of a CECL answer. In fact, we don't have any model where we look at a loan and add it to our existing portfolio and see how CECL changes before we decide to quote a loan. So that's not even -- it's not even on our mind.

Maybe we could talk a little bit about the funding side. Funding has been very strong. CLOs, securitizations, other options beyond the typical repurchase facilities that you have available to you. Is this hiccup in the market? Does that change the funding dynamic to you? And what's your expectation for funding costs going forward after, I guess, as of today? Greta would...

Sure. As you can imagine, we have been speaking with our warehouse credit facility lenders every day recently. And we have seen no changes from them. Now there's often a lag, they want to see it first in the capital markets, like if they saw the CLO market widening and staying wide, I think our repo lenders would revisit their pricing. But so far, that has not happened. I think if -- it wouldn't be the time this week to issue a CLO or do a Term Loan B debt financing. I think they're all wide. We've been told they're wide by anywhere from 15 to 25 basis points. But they're still available, and that's not a huge widening, in my view. I mean we've certainly seen more significant increases in other periods of disruption. But I think that we feel like the debt capital markets are very strong, very liquid and very available, at least through today.

Yes. The -- I guess, one of the aspects of that is that production likely would slow as we have to this kind of little volatility hiccup in the market. So is that an expectation that you have that your production might actually slow a little bit as people try to figure out the right pricing? And then once that opens up and the financing opens back up, is that kind of...

I mean I think a couple of things, I guess. I think it's hard to price risk in this kind of volatility. And so I think that slows down everybody. So it will slow down our borrowers. It will slow us down. I'm sure it's slowing down a lot of people in this room. I think the real question is, what's the duration of this volatility and how quickly or not are we all kind of getting back to business and willing to commit capital on a day-to-day basis? And I think none of us really know the answer to that yet. I think if you see persistent volatility, you can see origination volumes come down and you'll see repayment just come down. And so you have to look at your funded portfolio today and see what kind of earnings power that has. I would say on the financing side, part of the benefits of competition has been an acceleration or a creation of more options for firms like ours to finance ourselves. So obviously, there was -- historically, there was just the bank loan market, the repo market effectively. And then the CLO market has been very popular. And then we've recently done more term lending agreements, private CLOs, bespoke one-off financing with financial intermediaries where KKR -- really leveraging the KKR brand and relationships to help drive our financing costs and type of financing we get. So as we sit here today for KRF, 72% of our liabilities are not mark-to-market. So we're not on repos. And so we don't have to have a lot of these calls with our banks. And we made a big, big push in that space to try to diversify our financing sources. And that demand and thirst for yield is pervasive through our lending as well, right? So I think that's really what we've been able to try to take advantage of is turn what we see as competition in the lending market into a better way to borrow for our -- and finance our portfolio.

Greta, you could -- maybe you could talk about the asset classes that you are overweight in your portfolio and what areas you might be leaning towards or away from?

So we, last year, increased our exposure to office properties, and that is, in part, because our institutional borrowers were seeing more value-add opportunities there. And these were typically where the property has lost a tenant or is underleased for some particular reason, and it was a value-add play by our equity investor. So office, in many markets, is, in our view, very strong. I mean, in certain offices, we -- in certain markets, we see office rents to be flat, like Manhattan. I don't think there's a lot of rent growth in the New York City area, except in certain distinct pockets. But throughout the country, and particularly, life sciences, we've done a significant amount of that on the West Coast, and we really believe in that sector and think it's a good quality income stream coming from these properties with very strong sponsorship. We also continue to like multifamily. We sort of pivoted away from the Class A newer construction, as we've seen business plans or lease-ups slow in that and we've gone more to the mid-price sort of B-plus type of apartments, where we're seeing strong rent growth. I mean we found those -- they generally have been exceeding their lease-up plans from when we originated them and we continue to like that, not necessarily rent regulated, but naturally occurring affordable housing. And we still think that's a strong sector. We continue to not like retail. It's less than 1% of our portfolio. While we have tried to be open-minded and have seen a lot of transactions, we can't find one that makes -- we have not seen one that made sense for us. We continue to view that there is more downside risk NOIs there than upside potential. Hotels, we're highly selective on. We continue to like hotels in certain situations, so generally require very strong sponsorship and strong cash equity behind us. But it's still also a relatively small part of our portfolio at 13%, and we don't intend to grow that materially, particularly. Well, there may be opportunities in a coronavirus world where you find a really strong sponsor who -- where you can get unusual pricing, but that would have to be the case for us to add to that.

Matt, maybe you could talk a little bit about your portfolio as well?

Sure. Yes, happy to. So I mentioned, we obviously have a pretty big overweight in multifamily with almost 60% of our portfolio in multifamily and another 24% is in office. So those 2 really comprise the vast majority of the portfolio. So with those overweights, what does that translate into from an underweight perspective? I'd say hotels, we're very underweight. Hotels, we're sub-5% hotel exposure in our portfolio. We only have 2 loans in the portfolio that are hotels, both are on non mark-to-market financing facilities. And then we have -- we're underweight retail, sub-5% of our portfolio is in the retail. In terms of going forward, I think we'll probably stick to our knitting. I think there's a question around what's the new normal? Like if you get a real change in asset values, then I think we would shift and try to be opportunistic around that, like similar to what Greta mentioned, like if hotels, all of a sudden are so far out of favor that we think it's gone too far, and there's a good strong story that we can blend into there, we're certainly open-minded trying and creating value. But unless there's a real big sea change in how things are valued, I think, in the intermediate term here, we'll be sticking to kind of what we like in the portfolio today. And I think mortgage REITs are easy to understand in some ways because it's effectively loan portfolios. They're difficult to understand in other ways because one of the questions that I think is hard to answer is, what's the level of transition that you're lending on. And a lot of us talk about light transitional or moderate or construction. Within our portfolio, we've been really trying to position ourselves in what we call lighter transitional. So I explained the lease-up strategy of a multifamily. We would call that light transitional. There's no heavy lift at the asset level, it's just a lease-up play. On the office side, the corollary to that would be, call it, 60% or 70% occupied asset. So you have real tenants and cash flows in place. There may be some renovation at the property level. There could be a lobby renovation, there could be amenity packages being installed, there could be spec suites building out for new leasing. But it's not a rehabilitation or a major renovation of the asset. So that's really what we've been focused on in the office space. And less than 1% of our portfolio today is construction loans, which obviously comes with their own kind of complexity and risks. So I think as you analyze the sector, you kind of have to break it down a number of different ways and kind of level of transition, maybe one of those.

Greta, what's the proportion of construction loans in your portfolio?

It's like 1%. Very small. We've done 1 construction loan in the last 3 years.

Okay. I've got an investor question. Do you have mortgage loans with subordinated debt behind them? And what is the comfort level with mortgages with sub debt?

We do. We don't have many, but there are times where we want to provide a financing solution to a borrower, and we won't go as deep as the leverage request. And so we will typically simultaneously close with a mezzanine owner. I don't know the exact number off the top of my head, but it's -- of our loan portfolio, it's 1 or 2 loans where we would have subordinate debt behind us. So it's not -- it doesn't happen very often. But for us, the way we think about it is it's another credit enhancement, it's another entity or investor with skin in the game behind us. As long as it's not leverage that's so deep that your equity sponsor is playing a different game than long-term value creation, but typically, the sponsors that we're lending to at that asset size, you're talking about hundreds of millions of dollars of asset value, they're typically pretty well capitalized or maybe a specific reason for taking leverage up to 70% or 75%, or maybe it's just our view of value versus the market's view of value over the longer term, and we want that extra level of cushion behind us, which can happen at times, too. So we do it, but it's infrequent.

How about you, Greta?

The same. I mean, historically, the leverage that our institutional borrowers wanted was at a low enough level that we could provide it. But very recently, we've seen some -- we've been looking at transactions where there would be mezz. And in some cases, we absolutely love having mezz, particularly if it's strategic. We are looking at a loan right now where there is a significant office component in one of the boroughs of Manhattan. And if a significant office REIT that likes to do mezz or is a mezz holder, we'd be much more interested in the senior because we know that they clearly know the New York City office market, and it just gives another credit enhancement to the deal to get us interested.

Yes, makes sense.

What level were the modern [indiscernible] there.

It already has -- I mean, for instance, our weighted average floor in our -- for our 2019 originations is 1.9%. And in our portfolio, as a whole, it's in the -- I think, it's around 2.65, 2.63 for the portfolio as a whole. I'm looking at Bob back there but -- yes. I'm sorry?

1.63.

Okay. Thank you.

Yes, I would -- I mean, we're -- so for us, as of year-end, LIBOR was at 1.76%, 60% of our loans -- of our LIBOR flows were in the money on our loans at year-end. If you think LIBOR is at 1.50, then over 3/4 of our loans will be in the money. So there's a lot of -- depending on your rates view, there's a lot of earnings power in these companies right now from lower LIBOR. And then the question you have to ask yourself is, what's the duration of those loans that are in the money for us, in particular? We had a big origination quarter in the second quarter of last year. And so if you think about how long it takes to implement business plans and the call protection we put on these loans, we expect to have some duration to these loans. So we hope that will provide incremental earnings for the company on a go-forward basis. And the market is structured with LIBOR floors. So you would typically originate a loan, and depending on individual rates view and the negotiation that happens at the time, you would typically get a LIBOR floor somewhere between spot LIBOR and 30 basis points less than spot LIBOR, and every deal is different. But you're always kind of negotiating somewhere around that context to try to create that floor. And so they're worth a lot. And I would say these things aren't accidents. We clearly value putting these floors in place, and there are times, especially in the second quarter of last year when the market shifted their view on rates materially, first and second quarter of last year, I'm thinking about just -- it takes time to close these loans. But when you're quoting and signing up loans, and all of a sudden your rates view changes, there are definitely times last year where we were sacrificing spread for rate floor and saying, hey, we want to sign up this deal and maybe a little bit tighter than what we want, but we can put a rate floor in place of 2.40, and that's going to create a lot of positive returns because just as a reminder for the group here, none of our liabilities have LIBOR floors. So it's very powerful as LIBOR goes down to generate that kind of return.

But it is hard to ask for a floor that's out of the money at the time that you quote the loan. And you can get it in the app, what your floor is, but if it's dropped significantly by the time it's -- the loan's closing, you're going to have a conversation, or the borrower is going to have a conversation with you. We've been pretty successful in holding those. But at this point in time, if LIBOR is 1.50, 1.60, it's hard to have a floor of 1.80 on that loan.

ESG has become an increased focus for a lot of investors. I was wondering if each of you could talk about 1 thing that your company is doing over the next 12 months that could improve your ESG score. Let's start with Greta.

Well, we do put -- we do put this shareholder engagement and making sure we're at the forefront of proper governance provisions. We focus on that a lot. We recently changed our bylaws to allow for shareholders to have input on the by-laws. And that's a significant point. That affects your rating score. We just did this recently. It will be in our filing, our most recent filing. But that will hopefully change it. It seemed to be really important to those that create these scores. And in corporate governance, in general, I mean, we have 2 out of 7 of our Board members are women, and 50% of our senior management is women. I don't know if we get scores for that, but we'll certainly point it out.

How about you, Matt?

Yes. I mean, I'll set aside rankings for a second, but just in terms of initiatives and how we think about it. And I'm going to speak more from KREF's perspective. KKR has been a leader in ESG for many, many years now. But I think the question is more oriented to KREF and potential investors there. I would say a little bit more of the same, especially from the diversity perspective. If you look at our team, our real estate credit team at KKR that invests on behalf of KREF, almost 40% of our team is diverse. If you look at our Board, the same holds true. So 3 of our 8 directors are diverse. And so I think that's been a really important thing for us, and you'll continue to see us do that. I would say, just more locally, in terms of like, how do you think about it as a manager and as a team leader, we've made a big push to reduce our carbon footprint either that's through more VCC calls as opposed to in person and travel meetings, or just reducing printouts and more electronic and iPads and all that and trying to push that down to the team. And that's -- listen, it's a small thing, but I think part of this question is just what are we all doing individually that adds up to something important. And so I would put that in that smaller category, but maybe meaningful if everybody's backing that way.

[indiscernible] evaluation for these changes.

In terms of the evaluation from whom? Yes, I guess, not.

We're not. We're not right now. We're not right now.

[indiscernible]

Yes, we've spent a lot of time on that for many months, and we have language in all of our documents we've worked with. On the asset side, we've certainly addressed that in our documents, and it's a key -- with some borrowers, it's a key negotiating point. But we allow for the transfer to the predominant index at that time, which is probably SOFR. And we also have tried to make sure that the spread is preserved in the industry's language, in our -- in some of the other language that has been promoted, it allows for the spread to tighten if SOFR or whatever the index is higher than LIBOR. We're probably the one group, or at least our borrowers tell us, the one group that's insisting that our spread not change. But I don't understand how the industry accepted that. That's something that I've been adamant about for a few months. But we're very much involved in that. And we're also working with our lenders to make sure that we have as parallel a structure on our assets and liabilities as possible.

Matt, do you have any?

No. I mean, I -- the thing we're most focused on is as much flexibility as we could have in our loan documents. There's a wide range. It's a highly negotiated point. All your borrowers have a different expectation. And so there's a range in terms of what we have. But what we've tried to do is basically match what we have versus our liabilities to make sure that, that spread makes sense.

Okay. It looks like we're about out of time. So thank you so much for both coming here. Appreciate it. Thank you.

Thank you.

Thank you.