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

Welcome to the 9:45 AM session at Citi's 2022 Global Property CEO Conference. I'm Mike Crowley with Citi sales, and we are pleased to have with us KKR Real Estate Finance 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 and at the AV desk. For those joining us here today in person, to ask management any questions, please step up to one of the mics we've located in the center aisle of the room. If you are joining us remotely, simply type them into the question box on the screen and they will come directly to me, and we will do our best to ask them during the session. Matt, we will turn it over to you to introduce your company and any members of management that are with you today, and then we'll turn it over to Q&A.

Great. Thanks, Mike, and thank you for having us today. Unfortunately, you just have me. Matt Salem, I'm the CEO of KKR Real Estate Finance Trust, and we are a first mortgage transitional lender on institutional quality real estate to high-quality sponsors. And our portfolio is around USD 6.8 billion as of the end of the year and really focused on lending in major markets, top 25 markets. And about half of our portfolio is focused in the multifamily sector.

Great. One of the opening questions that we start off is, what are the top 3 reasons an investor should buy your stock instead of any other listed company in your sector?

Yes. I would say a couple things on that. First and foremost, it's a defensive stock. We're obviously comprised of a portfolio of large loans, again, to institutional sponsors. And we're generally lending in the 60s to 70 LTV. So in a market where there's some uncertainty, we've obviously got a pretty significant amount of equity cushion that can protect our book value. So one is just safety. Second is the yield on the stock is quite healthy. We're north of an 8% yield, so I think when you think about the risk corridor that you're getting exposure to within KREF, like I said, that bottom dollar in that mid-60s percent on a look-through basis, if you want to think about our leverage, generally speaking, we're financing our positions in the -- from the 0% to 50% LTV. So our look-through exposure is in that 50 to mid-60s LTV corridor, and that generates that net down to an 8% yield, which we think is very healthy. And then when you think about the go-forward here, what can happen to earnings? All of our loans are floating-rate loans. They're all -- so for either LIBOR or SOFR-based loans, and therefore as short-term interest rates increase, over time, we should benefit from that in the next few quarters and we possibly convex to increases in short-term interest rates. So in an uncertain world, I think safety, yield, and potential upside from an increase in short-term interest rates should be a healthy backdrop to invest.

Great. And if it's okay with you, I was going to start with some general questions and then we'll get into some company-specific questions. But maybe to start off, if you could share your CRE lending strategy and maybe how it differs from your commercial mortgage rate peers.

Yes. I would say that one of the biggest differences is just size. We are really focused on larger loans. Our average loan size is around USD 130 million, but we do lots of loans that are multi-hundred million dollars. So it's really an institutional product that we offer the market. We try to finance very large, sophisticated real estate investors, so folks that look like KKR from a financial wherewithal and experience perspective. So on the asset side, I'd say that's one of the biggest differentiators. The second on the asset side is really what comprise -- within that institutional framework what's within the portfolio. And I mentioned this earlier, but almost half of our portfolio is multifamily, which we view as a pretty defensive property type and asset class, and so that is very differentiated versus many of the peers and translates into what we think of as light transitional lending. So even if you take that same paradigm from property type into business plans on the office lending side of the market, for instance, we're generally lending on well-leased assets with a little bit of light touchup at the asset level to effectuate the remaining leasing plan. So think about an asset going from 70% to 80% or 85% occupancy and then getting refinanced. So the asset positioning is very low volatility, and we tend to play in the more safer sector of the market. And then we do have a big differentiation on the liability side as well. We've really leveraged the KKR brand and relationships to build out very safe and highly effective liabilities. Specifically, over 70% of our financing that we use on our first mortgage portfolio is fully non-mark-to-market. So I'd say whether that asset side or liability side, we have some pretty big distinctions versus the peers.

How would you describe the CRE lending environment today and maybe how it's evolved since the pandemic began 2 years ago? and are you seeing rational lending behavior from your peers and bank competitors?

Yes. And, obviously, today I'll maybe take it back a little bit and speak a little bit more broadly than some of the recent volatility that we're seeing from the war in the Ukraine. I would say #1 pipelines are very large. At the outset of COVID, you obviously saw a decrease in transaction activity and built up a little demand within the loan market. That is all coming back into the sector today over the course of the last year. So the pipelines for lending across our business and our peers is very high today. #2, those pipelines are also being driven by increased allocations to the equity markets. So if you think about alternatives and you think about real estate within the alternative segment, both of those are getting increased allocations of institutional and high-net-worth capital. So we've seen tremendous acquisition activity that needs to get financed in the market. So even though there is a weight of capital on the market, there's still a demand for yield within the market, that supply has really outweighed that other side of the equation and the demand. So the market is very healthy today from a lending perspective. One of the interesting things, and I alluded to this earlier, the loans that we make today, they're almost all spread. When we quote a loan in today's market, it's SOFR plus a spread. And given how low SOFR is or LIBOR going back into last year, we're creating very high spreads on our loans, even though the coupons are relatively in line. But what that means is, as short-term interest rates increase, we should be able to capture more and more of that economic opportunity through our loans. And then if you want kind of the simple answer of what's going on with ROEs when you factor in where you're financing your position and the asset origination yield, I would say that ROEs are largely in line with what we saw pre-COVID and with one caveat that there could be that upside from increases in short-term interest rates.

Great. You touched on this a little bit but if we could dive into it a little more. What are the areas of focus for you investing today and what are asset property types that you are favoring for lending and which are you avoiding and what about from a geographic standpoint?

Yes. As I mentioned, I'd say multifamily continues to be a very large segment of the market for us, and that will continue to be -- like I said, it's about half of our portfolio. Some of the newer sectors that we're lending in that have really benefited from COVID are industrial and life sciences. So those are probably some of the newer areas where we've seen so much demand for real estate there that our capital fits well into business plans, whether it's developing new industrial properties or developing life sciences or converting office to life science. So we've seen a lot of demand in those sectors. And then on what we're not doing, I would say, much more cautious on Class B office. Today I think that's the one sector where we've really raised the or heightened our conservatism. And then in retail clearly we haven't done a retail [ loan in a ] few years, but that I would expect to continue in this market. So largely we're lending in the favored asset classes where we're seeing real demand for real estate and a lot of acquisition activity.

Great. Are there other private non-bank lenders that are able to undercut your return hurdles? What risks do these funds -- firms play on the overall market?

Right. Well, I would say the risk/reward spectrum is pretty built out within real estate credit. The first thing to note is our segment of the market, so transitional lending, light transitional lending has become much more competitive over the years and is taking market share from a number of different segments in the market. So our business continues to grow. Our portfolio is the largest ever it's ever been. And we see a lot of -- certainly a lot of market opportunity today as I alluded to in the size of the pipelines. But, of course, there's lenders with a lower cost of capital than ours. There are some core plus funds, and on the really more stabilized part of the market, their capital can be a little bit more efficient. But I think one of the things we like operating in a public setting is our access to capital, our cost of capital, whether that's on the debt side or the equity side, is very effective. And when you combine that with our team, our franchise, and our relationships, we feel like there's a lot of opportunity for us, in particular, but obviously, the broader markets have a lot of access to or have a lot of opportunity as well.

Maybe I'll just see if there's any questions here. So you have mentioned 54% of your portfolio has a LIBOR floor of at least 25 bps with a weighted average floor rate of 0.74% as of the year-end '21, down from 1.64% a year ago. With the portfolio continuing to rotate out from higher rate floor loans, can you walk us through how we should think about the earnings profile of the portfolio in a rising rate environment?

Yes. I've touched on this a couple times, but maybe would be helpful to put a little bit of math around it. Pre-COVID, let's just think about ROE for a second. Pre-COVID we were lending at, call it, 11% to 13% IRRs or ROE, and we were doing that on coupons in the, call it, 4% context. So we would have LIBOR floors in place and then a spread on top of that. And then at the outset of COVID, obviously, you saw the short end of the curve or 1-month LIBOR go to effectively 0 and none of our liabilities had any floors in them, just our assets did. So it created a very significant NIM. And the translation to that is our expected IRR from 11% to 13% went to mid-to-high teens returns on these loans. Certainly, not what we underwrite, not -- we think that's a lot of relative value. Again, think about the segment of the market we're lending in. So we benefited greatly from these LIBOR floors. Obviously, as the market healed, those business plans were executed. We make short-term loans. Those loans are getting repaid now. And as those loans repay, like I said before, we are resetting our LIBOR, or in today's market SOFR floors back down to the existing 1-month equivalent, so somewhere between 0 and 20 basis points in this market. And so what will happen over time is those really high-returning loans that have LIBOR floors will roll off, so our mid-to-high teens returns will roll back down to that 11% to 13% ROE, and then as rates start to go up, we can start to earn more on that as we've effectively reset our position at a floor of almost 0. So maybe a little bit better lucky than good, but we've benefited a lot from these floors and now they're all rolling off and rates are going to go up and we're going to benefit again. But that's the way we're positioned. And from a timing perspective, we think that we'll become positively convexed to short-term interest rates in the next quarter or 2.

Your portfolio's credit performance has been solid with 100% performing loans. The recent repayment of this USD 76 million 4-rated hospitality loan was also a positive. What are some of the conversations you've had with the remaining 3 watchlist loan borrowers and what is your expected outcome from the loans?

Yes. So I'd say, this will give you some perspective and history. We didn't have any watchlist loans going into COVID. At the outset of COVID, we threw everything we thought that could be impacted onto our watchlist. So hotels, New York City condos, short-term maturities, et cetera. And that was 7 loans. And as you mentioned, that 7 has now come down to 3, and we've got 1 industrial property or a loan on an industrial property in Queens and then we have 2 loans on condo conversion or condo buildings come to condo buildings in Manhattan. The short story is I think we feel very positive about all 3. Those business plans are making significant headway. On one of our condo inventory loans that's been paid down from USD 240 million down to USD 40 million, so it's almost gone. The industrial property we've been giving a couple of short-term extensions to effectuate a sale. So I'd say, overall these business plans are certainly moving in a positive direction and over time we'd expect -- we could expect those to return to either repay or return to performing.

Your CRE portfolio balance grew by 35% throughout 2021 at USD 6.8 billion and further to USD 7.1 billion as of 2/4/22. Can you talk about how we should anticipate the portfolio growth for the years ahead? Is there an optimal level of size or limitations to the growth that you can handle with the portfolio?

Right. Well, I would say that, #1, market opportunity drives the growth. So it's all about what we're seeing in the market and whether we think we can -- what we're -- the loans that we can make are good risk-adjusted returns. Obviously, what we're doing today we like a lot. And we have a really scaled team. So within KKR Real Estate Credit, we've got over 50 people on the team. We've got a deep -- really deep client base and strong relationships there that creates a lot of opportunity for us. And so we expect to continue to be able to grow the portfolio over time. Just last week, we did a equity issuance and thanks Citi for participating in that. And if you just take a step back, think about what our origination volumes could look like, we've been averaging over USD 1 billion a quarter in originations. So think about it as USD 4 billion of annual origination capacity could be higher depending on what the market looks like. And when we think about repayments this year, we've gotten through a lot of the heavy repayments coming off of I'll call it pre-COVID portfolio, and we could see repayments and the magnitude of call it USD 2 billion or so this year. So we've run a couple equity raises. We did a preferred equity deal in January. We just did a common deal last week, which will affect -- help capitalize that pipeline. But I think you'll continue to see us look for opportunities to grow over the course of the next few years simply because it is a big market, and I think that our team is able to really generate some pretty exciting investments. But we'll do so in a very prudent way. We are the largest shareholder, KKR & Co. is the largest shareholder within KREF, and I think you've always seen us approach capital markets activity and fundraising in a judicious manner.

Maybe just to add on to that. We're 2 years into the CECL adoption. Do you think that has changed how you view origination opportunities, if any?

We don't know is a simple answer. We actually don't think about CECL at all when we originate a loan. So it's really a back-ended process that we run towards quarter end just looking at the portfolio as a whole. But I would say that CECL is not in any green line or preview committee memo, it's not discussed on pipeline, it's not in any IC memos. So it's really, to some extent, like I said, not an afterthought but it's really run at the end of a quarterly process and doesn't drive any decision making as it relates to new loans.

You've always had solid diversified funding sources and a high percentage of non-mark-to-market financing and closed 4Q at 71%. At this point, are there any other funding options that you would consider to add additional mix to the right side of the balance sheet?

Right. So we've spent a lot of time developing facilities that allow us to finance our portfolio, not only on a cost-efficient basis but on a non-mark-to-market basis to create that safety. And certainly, at the outset of COVID, we were quite pleased to have our portfolio financed in that way. And we've also put in other features -- financing features within our company, like our corporate revolver, which gives us access to capital whenever we need it. And we've taken advantage of the capital markets as well in terms of the issuance of CRE CLOs. We have 2 of those outstanding today. And as you mentioned, that diversification is really important to us. We added Term Loan B, we've done preferred equity issuance as well. So we really are trying to create a capital structure that is really robust and that's led to, as I alluded to, over 70% of our portfolio being financed on a non-mark-to-market basis. I would say our effort, energy, creativity as it relates to trying to identify new non-mark-to-market facilities has not stopped. So we'll continue to use all the resources within KKR and the brand that we have in the market to deliver more of those facilities which really are best-in-class and our peers don't have similar type of facilities. And then as we grow, and as I mentioned, not growth for growth sakes, but growth does give us access to other pockets of capital. So certainly, some of our peers are in the corporate unsecured market. So we could start to think about things like that as our business scales over time.

We have a question coming in. Do you see the investor base growing for your CRE CLOs? How was liquidity for the bonds changed in the last couple years?

Well, we have 2 outstanding right now, and we've done 3 total. So we're not the biggest CRE CLO issuer, but I could certainly give you our perspective. I think that whilst we hit record CRE CLO issuance last year, it tends to be a favored financing tool for many transitional lenders in the market. It's not our favorite, but we use it as a piece of the capital structure as I just described. I do think that the market -- the individual investor base there is a little narrow, and I would expect that to increase over time. The market just now, [ after ] the record issuance last year, is creating I think enough size trading volume, et cetera, that bring in new investors into the space. There are obviously very sizable investors, most large treasury portfolios of U.S. money center banks are invested in the sector. And so it does have some very large participants. But I still think it has room to grow especially when you look at it versus corporate CLOs and the amount of activity that's done there and the number of participants in that market certainly can translate over into CRE CLOs a little bit more. So while it's been around a long time, I still think it feels a little bit young on the investor side and can mature.

Your company ended 2021 with a debt-to-equity ratio of 2.3x. How should we think about that moving ahead and would you be willing to bring that up further to boost returns?

I think we've been pretty consistent in terms of how we finance the portfolio. So whether it's a debt-to-equity ratio or the total leverage ratio, we've always kept it in the -- think about debt-to-equity is 2.5x and our total leverage ratio in that 3.5x to high-3x context for the most part, and that'll be stable going forward. Obviously, it moves around versus where we are on equity issuances, and we've done a preferred deal this quarter and a common deal. But we really aren't changing our targets to increase returns or generate more earnings. I would think about -- I think about our capital structure on the debt side is relatively consistent from a leveraged perspective, and we do the best deals we can on the asset side, and whatever comes out of that is the earnings that we can deliver and the dividend that we can pay.

What's one area that you think investors are underappreciating about your company or your strategy that you'd like to highlight?

A couple comments on that front. One, we sit in this broader KKR ecosystem, and we have a very collaborative environment. And so when you think about KREF or you think about KKR Real Estate Credit, you're really getting much more than that because we're affiliated with the broader KKR enterprise. So we sit fully integrated with and alongside a real estate equity investing business who, by the way, buys properties and implements value-add business plans similar to what we're lending on. So we're leveraging that expertise and experience into our due diligence. That's a large platform that has a lot of market connectivity, so we can leverage their contacts and market as well from a sourcing perspective. But it doesn't just stop within the real estate side of things. You can pull that out and translate it over into corporate credit or our private equity teams. You think about an office building with underlying tenants that may not all be public will be able to leverage the corporate credit side to help us understand individual tenant risk or if we're landing on a life science building, pulling in our healthcare teams, some of our growth teams to look at the life science tenants or the market, it's been really invaluable. So you're getting the larger I'd say ecosystem on the asset side to help us evaluate risk. Second, and I mentioned this earlier, if you look at our liabilities, we really have a best-in-class liability structure from a non-mark-to-market perspective and that was all created by the broader firm using our relationships, using our KKR Capital Markets business to deliver these unique facilities that help us finance our portfolio. So that's what is just the broader firm is very valuable to KREF. And then let's just narrow it down a little bit. Think about KKR Real Estate Credit and what we do in our business. KREF is our flagship transitional lending vehicle, but outside of KREF, we made or our total originations last year, including KREF, we made over USD 14 billion of loans last year. We're a very sizable lender in the market, and we have an insurance capital, and we have obviously this type of value-add capital. And that's allowed us to create really broad-based relationships across property owners in the market. And I think about KREF is like sitting on top of that from an allocation waterfall perspective. It's got first pick in everything we do on the transitional side. So think about this big team with deep relationships, sourcing opportunities, originating over USD 14 billion of loans and KREF picks what it wants. So that's why we've seen some of the growth in the portfolio. And then, finally, and this is what I alluded to at the -- or discussed at my opening comments was, maybe it's more of a broader industry comment. But the mortgage REITs rates are I think really well positioned for success going forward. We just had a stress test through COVID. Our portfolio did exceptionally well. We've grown book value every quarter for I think 7 quarters straight, so have had really good performance in the underlying portfolio. We talked about the watchlist loans decreasing and the comfort with the existing ones. And it's a defensive -- obviously, it's defensive. We've got institutional owners of real estate with real significant equity cushion behind us to protect us from any near-term volatility, and we deliver a good yield that could potentially -- our earnings could potentially increase over time as you start to see the short-term interest rates. So when I think about all those components, it feels like a pretty good set up for KREF in particular, but certainly, the industry's got some tailwinds also.

Thanks, Matt. I think that will -- we'll close there, but one quick rapid-fire question that they asked us to ask you is what will the 10-year treasury yield be a year from now today.

Those people are a lot smarter than me that could probably rate call. I'm probably more of the camp that if I had to pick a number -- by the way, everyone should not write this down, but I would pick 2.5% I think when you start to think about the front-end of the curve and the potential rate hikes that are going on, for me, it's just hard to imagine the curve being that flat when you think about overnight versus a 10-year risk. So I'm probably a little bit more on the steepening bias over time, but certainly not what the market's telling us today.

Great. Well, thank you very much. Really appreciate it.

Thank you. Thanks for having us.