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

Hi. Welcome to Citi's 2021 Virtual Global Property CEO Conference. I'm Arren Cyganovich. I'm With Citi Research, and we're pleased to have with us KKR Real Estate Finance Trust and CEO, Matt Salem. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. For those joining us here today to ask management any questions, simply type them into the question box on your screen, and they will come directly to us, and we will do our best to ask them during the session.

So Matt, we'll turn it over to you, and you can introduce your company. And maybe we can start off with coming out of the pandemic, if an investor were to choose only 1 real estate stock to own, what are 3 reasons why they should invest in KREF?

Okay. Thanks. And Arren, appreciate you having us with you today. And thank you, everyone, for joining. I apologize a little bit. I may be shifting around. I'm trying to avoid some of the sunlight coming in this morning, so -- but just as an introduction, we're here to talk about KKR Real Estate Finance Trust, which we call KREF, which is a mortgage REIT really focused on lending on transitional properties to institutional sponsors and institutional quality real estate. And then to answer your question around why invest in KREF today, I think it comes down to a couple of things. Number one, the portfolio. We have a very strong portfolio, again, comprised of larger loans on institutional quality real estate. And we've just been through a stress test. And so now we know how kind of the industry performs through a pandemic, through a down cycle, and we came through that quite well. So the performance has been very strong, and we can talk more about that. And then from an earnings perspective, last year was a record year for us and -- largely driven by the performance of the portfolio, but then also the way our assets are set up. We have LIBOR floors in place on our loans. And so as LIBOR decreased, our liabilities don't have those same floors. So our NIM increased, creating a lot of excess return in the company. And we're going to have that for a while until those pre-pandemic loans kind of pay off and recycle into the new loans. And then I think that brings up kind of the third point, which is just growth. And the way we're positioned today, with the earnings that we have with our existing portfolio, we think we're kind of poised for growth over the near term. So the setup, I think, is pretty strong for investing in KREF. We've got a strong dividend and a very low interest rate environment. And I think that should be attractive to investors.

So thinking about where we were a year ago where the pandemic was really just starting to evolve in the U.S., maybe you could describe how the CRE lending environment is today and how it's evolved throughout this past year during the pandemic and maybe touch a little bit on how you think it's going to progress over the next few months?

Sure. I think like most other investors, in the first quarter of last year, certainly in January and February, I think we were pretty bullish on the market opportunity. Our originations were high. And then, of course, March hit. Like everyone, it was quite sudden and quite a shock. And we immediately went into kind of asset management, liquidity management mode. And that was really in that late March, April time set. But for KREF, it didn't take us long to realize that the portfolio was quite strong that despite the pandemic, it was going to perform well, that our liquidity was -- we had a lot of excess liquidity, and then our liabilities were very resilient. So we quickly shifted to offense, I would say, by -- really by midsummer. And then the issue was really around transaction volume. And you just -- there wasn't a lot of opportunities to lend until really that coming out of August, I would say, end of the fall, where you started to see some activity pick back up. And that's really when we started lending again around that opportunity set. And our volumes in the fourth quarter were quite strong. So we had over $550 million originations in the fourth quarter, and that will continue into the first quarter. Our pipeline's big. We signed up a bunch of deals, and you'll continue to see us kind of active right now. So that was a little bit of the storyline over the course of the last year. And what are we seeing today versus pre-pandemic loans? Clearly, there's more caution. I'd say, when we're underwriting, we're more conservative on the underlying assumption. So what are rents, what are -- what is the time to lease these properties up? We do a lot of multifamily. So what are the concessions offered in the market? So there's an extra level of caution and skepticism around the business plans, which, I think, everyone should expect. And some of the terms are more, obviously conservative. I think leverage and structure are more in the lenders favor today than they certainly were pre-pandemic. And then when you want to translate that into like coupons, coupons are slightly inside of where they were pre-pandemic. Base rates are down 100-plus basis points. So I think that's to be expected. So if you want to just go coupon to coupon, I would say pre-pandemic, we were lending at, call it, high 3s to 4% all-in coupon. And today, we're lending at mid-3s to 4% coupon. So still in the same range, but probably slightly tighter. However, if you think about the mix, it's really changed from a component of base LIBOR because almost all of our loans are based on 1-month LIBOR to now all spread. So let's go back, pre-pandemic, we may have made a loan at a 4% coupon, but it had 150 basis point LIBOR floor. Today, we'll make a 3.75% coupon loan with a 15% or 10% -- or 10 basis point LIBOR floor. So it's all spread. And that has implications, obviously, for our current returns, but it also has implications -- positive implications for the future. If you think about kind of resetting the portfolio into these lower LIBOR basis, well, to the extent we see inflation to the extent LIBOR, short-term rates begin to go up over time, we should benefit from that increase.

Okay. That's very helpful. Maybe you can just talk a little bit about the areas that you're focusing on today. We've heard a lot of folks discuss kind of avoiding some of the more pandemic-hit areas in this current environment and certain areas that seem more attractive today versus last year?

Yes. I don't think anybody was perfectly set up for a pandemic. But if you looked at our portfolio going into it, I think we were as well positioned as anyone could be from a property side perspective. So over half of our portfolio was multifamily. When you add in light transitional office, it goes up to 80%. And retail and hotels were sub-10% of the overall portfolio on a combined basis. So we were set up very well going into the pandemic, and that was unusual. I mean, I don't think any of our really scaled peers have their largest property type in the multifamily segment. And so now, what do we do? And where are we focused? I would say, it's still probably more of the same. We historically like multifamily. I think, it was -- 90% of our fourth quarter originations was multifamily. So we're going to stick in that property type. We've got a deep client base there, and we really do like that segment -- we continue to like that segment of the market. So I think a lot of it is more of the same. We've always focused on light transitional loans, and we'll continue to do that. You saw that in some of the office loans that we've been focused on. But we're changing as well, and we're adapting to what we're seeing in the market. And I would say, 1 example is just coming out of -- or during the pandemic, the demand for industrial space, driven by e-commerce, is just quite significant right now. And so that's an area where -- we always liked it historically, but it was hard to invest there. And -- but today, with the amount of demand we're seeing, with the need for new space, we've been active in that sector. We made a construction loan -- almost $100 million construction loan in the fourth quarter to a Denver -- to an industrial property in Denver. And so like that's an opportunity where it's like, okay, that's somewhat new for us, and we're going to move into that sector. And there's other things that have been accelerated by COVID, like life sciences, like data centers and things like that, that -- I think, that we'll continue to look at it and could become a part of our portfolio. I don't think we're looking for like the dislocation opportunities, the retails and Class B office and things like that I think are -- it's too early to tell. And obviously, there's real secular headwinds in some of those areas. So we'll most likely stay away from those and try to play the areas and invest in the areas where we've seen acceleration in growth.

One of the things that some folks have been talking about in the industry is that, given that there's an increased focus away from areas that might be a little bit riskier, and we don't know exactly how things will unfold, there does seem to be a lot of focus on the same types of properties, in the same high-quality types of properties with a decent amount of capital still kind of available on the sidelines. Is that -- you mentioned the spreads haven't really been compressing or spreads are actually some kind of widening versus last year. Maybe you could just talk a bit about that dynamic when there's a lot of capital kind of chasing some of the similar property types?

Yes. I mean, I think that clearly, one of the things coming out of this is that real estate has a very defined kind of have and have-nots, and the acceleration versus the dislocation. And real estate lending is in that same position. And we -- and quite frankly, we have seen some of our competitors on both the public and private side kind of pull out our old playbook and move into the multifamily sector in a much bigger way. And so how do we offset that? How do we compete? And I think we do it the same way we always have historically, which is we've got a very strong client base. We have existing relationships that we're able to drive deal flow through. And everyone should just keep in mind, everything we do -- the vast majority of what we do is all bespoke. They're all individually negotiated transactions. So these aren't syndicated loans like in the corporate world, like we make these loans. We negotiate each document, and we build relationships with our sponsors. And these loans typically have reserves and escrows associated with them that there's an ongoing discussion and dialogue in asset management with the sponsors. I mean things won't always go exactly as planned and there's needs to have a discussion, right? "Okay, I need this reserve now or let's save it until later." And that we're always evolving and adapting to those needs. And so that's how you build relationships. So I think that our existing relationships will help drive deal flow. 40% of our flow last year was -- our origination volume was through repeat sponsors. And so we've got those relationships that we can leverage. The second thing I would say is we're a finance company, so we've got to have really efficient liabilities. And I think that's where we can kind of outshine the competitive set as well and really -- and historically, we've delivered some really outsized returns based on the risks we're taking on the liability side. But it's certainly on the middle of the fairway, multifamily property. It's more competitive today than, I think, it was -- than it was historically. But again, there's new sectors we can invest in as well. And so that's part of the equation also is, "Okay, how much capital do we want to allocate to some of these newer accelerators or industrial properties, et cetera."

Okay. You talked about kind of the sponsor relationships that you have. How's the view of the sponsors currently in this market? You mentioned kind of getting more back on the offensive late -- or not quite late last year, but in the summer last year and seeing that come through in the fourth quarter. What are you seeing from the sponsors in terms of their kind of willingness and then just the level of kind of activity that's happening right now in those kind of discussions?

Yes. Well, I'd say, first of all, one of our biggest differentiators going into the pandemic was the quality of our sponsorship. I think we had as high a bar as anyone, if not the highest bar in the industry in terms of who we would lend to from a sponsorship perspective, despite the fact that we're making nonrecourse loans. And I think we're even more convicted in that today than we were then in terms of like we've seen them perform. We understand exactly how our sponsors think in a really, really difficult real estate market. And I think what we've seen is that sponsorship matters a lot and not just access to capital, but how they approach their business plan, their patience, they're willing to put in more equity and ride through potential -- these downturns. And I would say that what we're seeing -- and listen, we're living the same thing in terms of like KKR Real Estate. Keep in mind, I sit within a bigger real estate business at KKR. So we've got an equity side of our business that, as you'd expect, isn't by investing in private funds. And I think we've seen all of our sponsors turn back on. Clearly, the amount of liquidity in the market today, the low interest rate environment, the need for yield, the need to invest capital has really turned on -- or turned our sponsors back on from that kind of initial shock and all of the onset of the pandemic. And I'm generally bullish on real estate just because alternatives are going to be a huge part of people's performance and allocation across the globe. And so I think we've seen a lot of activity in the markets. Everyone is trying to figure out how to invest capital today. And again, it's difficult because, like I said, there's kind of the have and the have-nots, and there's a lot of capital going after fewer sectors, but we're going to stick with our sponsors, and they are, I would say, very active. But if you translate it into our pipeline, like I said, our pipeline is extremely robust right now. And some of it's pent-up demand, but a lot of it is new activity and new investments.

You historically had pretty big part of your portfolio in multifamily. How are you thinking about the trends in multifamily? We've seen some of the -- a bit of migration to the suburbs, deurbanization trend. What are your thoughts about the -- or maybe you could describe what kind of multifamily you typically are investing in, and how that's performing thus far?

Sure. Yes. So over -- about half of our portfolio is multifamily today as of the fourth quarter, and we generally run north of -- in that context to slightly higher than that. And it's predominantly Class A assets, so higher quality. One of our bread and butter lending products is construction takeout loans. So the multifamily property has been built. It's been delivered. It's in the initial stages of lease up, and then we're providing that capital to take out the construction loan and bridge that time period for the lease-up and the roll-off of concessions to a stabilized loan or a sale if you're lending to a merchant builder. So that -- we run that playbook, many, many times. We really like that. We really like that investment product because we don't have the construction risk. And we just have to make assumptions around the timing of the lease-up and the rates, but we can look into what's been done at the outset. And at the initial lease-up stage, you kind of extrapolate into what we think will happen over the following few years. So if you think about that, where have we played, it's been in a lot of the growth markets. And so we've done that. And most recently, like in the fourth quarter, we did it in Denver, CBD Denver. We did it in Northern Virginia just a couple of miles away from Amazon's new headquarters down there. And so we'll continue to play the growth markets. And we're still very comfortable with the multifamily sector. Most -- again, most of what we're doing is more of the Class A segment of the market. We haven't done a lot of the kind of the B and the B-plus conversions. We'll continue to stay in that higher quality segment. And we do focus on major markets. I know a lot of people are worried about the urban centers and certainly have to be more cautious and underwrite more concessions today and longer lease-up periods. But we still think that the top 20 markets, top 25 MSAs will continue to be highly investable from a multifamily perspective and very, very liquid and transparent, and that's where we like to be as lenders. And listen, capital markets activity is still strong in those markets. Last year, we got repaid on 2 of our single largest New York City exposure and then another large exposure in the Tri-state area in multifamily. So there's a lot of capital for those high-quality assets, even in the most urban centers.

Okay. And maybe we can discuss office a little bit. Office is another area where you tend to have a bit of higher focus. Office, obviously, I've been working from my home for about a year now, and I'm anxious to get back to the office. I don't know if I'm one of the few, but really kind of how do you think about office? I don't know if the sponsors have much say in terms of their willingness and the trends that you have in your portfolio, but that's clearly an area to think longer term people are wondering how that's going to unfold over the next few years.

Yes. Yes, and I've been working from home, too. Obviously, as I dodge the sunlight coming in the room here. But a couple of things. About 30% of our portfolio is office today. And thankfully, we really focused on, what we call, light transitional, which means different things. You hear a lot in the market the different commercial mortgage REITs. To us, on the office space, that means pretty well leased. And so if you look at our office portfolio, today, it's around 70% occupied. And so it's different than what I described on the multifamily side, where you're lending on a newly build asset, but it's in lease-up. On the office side, what we're typically trying to do is lend on a mostly leased asset that is going -- typically undergoing some type of light renovation and amenity package and renovation of the lobby and elevator cabs and maybe you're adding the cafe or the gym or other amenities for the tenants. But it's not a big renovation plan or a full rehab of the asset. So we sit at over 70% occupied today on our portfolio. There's a long weighted average lease term north of -- or higher than 6 years. And so that's where we've focused, and we'll continue to do that. So we think that that's still a viable strategy in the market. I would say that we're probably more focused on the Class A segment of the market than the Class B, B-plus, A-minus segment going forward. I do think this will change the way people will use office. I'm not convinced there will be a big decrease in demand for office beyond what the impact is from just a recession. Is there a real secular change? I don't know yet. But as a lender, I don't think we're getting paid to make that bet. And -- but I do think that people are going to want higher quality assets. They're going to want their people to be in really environmentally friendly buildings. And so I think our focus will shift to -- I mean, it was before, but probably have a little bit tighter lens in terms of focusing on the highest quality assets in the market. And clearly, from a transition perspective, in the market we're living in now, you just don't want to take a lot of lease-up risk in any recession. And so we'll probably be pretty defensive as it relates to like what's the existing tenancy look like and how long are those lease terms? And is there really enough there to support our loan amount? I don't think we want to bet a lot on future lease-up until we understand the market a little bit better.

Okay. And then maybe we can just touch on areas where you've thankfully been, I guess, under weighted, and that would be in hospitality and retail. You have some exposure in your portfolio, but not a significant amount. You can just discuss how that's trending? If you're seeing any transaction activity? It seems like transactions have been still pretty sparse. And whether or not the cash flows of any of those, within your portfolio, are supporting the assets themselves?

Yes. Well, we have 2 -- let me start -- let me just take the hotels. I think that's the area where we see the most interest today, and we have 2 hotel loans in the portfolio. So it's not a big part of what we've done historically. And the performance has been strong. We have modified those loans, obviously, to give our sponsors a little bit of relief. However, we didn't give them any -- they were just interest deferrals. We didn't waive any of the interest that was due, just kind of changed the timing of that. And that was in return for equity -- new equity coming in from our sponsors, so additional kind of capital commitment to the assets. And both have improved substantially as, I think, everyone would guess. Kind of as we've gone through the pandemic, one of our assets is the W in Fort Lauderdale. And clearly, that went from shutdown by Broward County to this last 4-week period, it's operating at over 70% occupancy. So we've seen a big bounce back in performance. And I think going back to the fall of last year, this is an area we want to lend in. Hotels, as we all know, are highly cyclical. We're at the bottom of that cycle, most likely. And we're actively looking for opportunities to lend. We just haven't seen the pipeline develop that much. And I think there's a question around -- obviously, the existing lenders that had those modified their loans to give their sponsors more time just like we did, which makes all the sense in the world. But, at some point, there has to be some recapitalization in the market. And I think that's the question is kind of how fast do these markets come back versus that need for additional capital and recapitalization. And we would like to add -- increase that part of exposure in our portfolio. They're attractive rates today. It's just the opportunity set isn't quite there.

Okay. Maybe we can switch a little bit to the funding environment. One of the kind of interesting things when we talk to folks in the industry is that, while the -- you have a benefit of LIBOR floors today, which will be kind of rolling off and transferring through, the funding environment is very attractive today. Maybe you can talk about like the all-in returns, and how you think -- you have a negative pressure from LIBOR -- kind of LIBOR floors falling off, but maybe where you can kind of benefit on the funding side a little bit?

Yes. So just to kind of go back to my original comment to set the stage here. We had record earnings last year and -- again, driven by the performance of the portfolio, but really the increase in that net interest margin that we're receiving on the portfolio. And the vast majority of our assets have LIBOR floors and hardly any of our liabilities do, and that's what drove that increased NIM. So let's just translate that to something. To ROE, when we underwrote our portfolio, we thought we were going to make 12%, 13% on these loans. Well, as LIBOR rallied and created that excess NIM with those floors, we're currently making mid-teens to higher on our existing portfolio. And that's what's driving the record earnings. So it's great. We're outearning the portfolio, but we didn't underwrite that. And we plan to have LIBOR floors. We knew we were kind of long option, if you will, but that certainly wasn't our base case underwriting that we're going to make mid-teens on these types of high-quality loans. And so as the portfolio transitions out of that LIBOR floor into new loans, we'll see that return come down again to more historical levels. So we're going to go back to that 12% to 13% return is our expectation. And then the question is, "Okay, well, how long does that take?" And we tried to message in our last earnings call that we think that could take the course of this year, that our repayments will most likely be back-ended here and you just take a step back and say why is that. It's because it's taking longer to lease these properties up. Half of our property -- half of our exposure is multifamily properties. And obviously, those are going to take longer. There's more concessions in these markets. And it's not a credit concern. I wouldn't look at that as like, "Oh, they're not repaying. That's bad." We're talking about another quarter or 2 of kind of extension on these business plans, which the loan, obviously, affords. These are typically 5-year loans. There's plenty of time. But if you think about our sponsors, these are well-healed sponsors. Those are institutional sponsors with managing funds of billions of dollars, and they're not going to go sell into the market in an opportune time. They've got plenty of capital to wait it out and lease it up and burn-off concessions. So that's what we're seeing. And so as we look ahead, we think we're going to sit on this existing portfolio for longer than we thought, which is good. It's going to drive earnings. And then as we rotate into the new loans, what's the benefit there? Our earnings will come down a little bit, again, to where it was historically pre-pandemic is our expectation. But what are we doing? We're also creating another option value that we're resetting our coupons to almost all spread and a LIBOR floor of like 10 basis points. So if you think LIBOR is going to go up over the next 2, 3 years, well, our portfolio is going to increase in value from an earnings perspective. So can we time it right? Can we kind of get the portfolio to runoff and recycle into all the wider spreads and lower floors and then have LIBOR goes up? Well, that remains to be seen. But that's kind of the setup of the earnings of the company and the kind of the portfolio as it relates to interest rates.

And what are you thinking about in terms of portfolio loan growth? Are you thinking more of a recycling type of environment? And what kind of leverage can you get on new lending? Is that something where you might be able to expand leverage over time? Or how do you think about that?

Yes. I mean there's ample -- this is part of your last question, which I don't think I got to, but there's ample leverage available in the market at very attractive cost of capital. I would say our existing loan portfolio, we were around $5 billion at the end of the fourth quarter and announced some additional closings and loans that we had signed up. When we think about our portfolio optimized with existing capital base, not too far from where we are today, 5.3, 5.4, 5.5, it's in the context of where we are today. And so really, we're going to have to match our portfolio growth or new originations with repayments for the time being. And then the question is -- because I don't think we want to add leverage into the company right now. But we've got an attractive setup. Like I just described, we've got great earnings. We're paying a very big dividend in a low interest rate environment. And the portfolio is in great shape. And so I think it's on us to kind of go out and make sure that investors understand that story. And hopefully, we'll have access to equity capital at some point in time because the pipeline is robust, and we can generate the same type of returns we did pre-pandemic. And so the dividend looks stable, and we'll see what happens, I think, over the course of the year, but we would like to grow -- continue to grow the company, grow the portfolio. But right now, we're really focused on equity.

Okay. All right. Well, I think that about wraps us up. So we really appreciate you joining us. And hopefully, next year, we'll be back in sunny Florida and enjoying the nice weather there. So...

I look forward to that. And Arren, it's good to see you, and thank you for inviting us at this conference. And thank you, everyone, for joining today.

Thanks.

Thanks a lot.