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

Hi. Good morning. Thank you for joining us today. I'm Stephen Laws, research analyst at Raymond James joined today by Matt Salem, CEO of KKR Real Estate Finance, ticker KREF. I appreciate everyone joining us today.

Matt, to start things off, given the REIT historically is primarily equity refocused, maybe can you give us a 2-minute overview on KREF and the mortgage REIT focus and business model, I think, would be a great place to start.

Sure. Happy to, and thank you for taking the time out to do this with me. And thank you, everyone, for joining today. Simply, KREF is focused on lending on senior secured or first mortgage loans to institutional sponsors on high-quality real estate located in major markets. So we like to think of -- I'd like to lend to people like ourselves, very large institutional owners of real estate. And then everything we're doing is predominantly floating rate. So these are short duration floating rate loans with a typical structure of a 3-year term and two 1-year options on the back, so 3, 1, 1s. And then we finance those on a match term basis, largely on non-mark-to-market, nonrecourse facilities. So about 3/4 of our overall portfolio is financed with very safe liability structure. And then finally, I would just add that the company is externally managed by KKR. So you get all the benefits that comes with being associated with the broader platform, whether that's sourcing or liability management.

Great. And to kind of start with the portfolio. Looking at the mix, you guys are overweight multifamily relative to a lot of your peers. Can you talk about how that's helped your portfolio performance in the past 2 years and then outlook on multifamily loans that you're originating today?

Yes, sure. We're a transitional lender, to start. So we're lending on assets that are in some type of transformation. And that can take a lot of different forms. You can have construction, you can have major renovations happening. You can have lease-up plays happening. You're going to have light renovation. You can do it across different property types. And really going into COVID, we had the mindset that it was a very competitive market. And we weren't getting paid a lot of return for taking incremental risk. And the multifamily segment -- with that mentality in mind, the multifamily segment looked particularly interesting because we could lend on newly built assets and effectively take out construction loans and give the borrowers time to lease the property up, so a bridge to stabilization. And we thought that business plan was relatively straightforward, easy to underwrite and obviously benefits from the structural fullness in the housing market that I think we all -- that we all know about. So we had really started repositioning our portfolio before COVID, it was well over -- multifamily was well over half of our portfolio going into COVID and we've kept with that theme as given everything we've obviously seen in rents and that structural tightness of the overall market. Today's lending environment, we can talk about this more and some of your other questions, it's certainly different than what we've seen 12 months ago, 18 months ago, where it's more of a lender's market today. And so leverage has dialed back I think, in anticipation of price changes and/or valuation. So today, we're lending in the, call it, low to mid-60s LTV. There's a lot more structure and pricing is -- has widened out as well, just given the overall global macro environment. So we still like the sector. It's adjusted to the realities of today and the volatility of today. But again, a lot of tailwinds in the housing market, as we all know. So continue to invest in that segment of the market.

Great. And to touch on the other property type that typically has the highest exposure to mortgage REITs is office. It's not your highest exposure, you're underweight relative to many of your peers. Can you talk about the performance you've seen of your office loans and kind of how you view that asset class today as you look at new origination opportunities.

Sure. I think as everybody would expect, quality really matters in this segment of the market. And I would say, on the Class A segment of what we lent on in the office space, which is about -- it's over 90% of our office portfolio is in Class A. We continue to see strong demand. And we're generally in the growth markets there. And so that's clearly helped those tailwinds and demographic trends, especially in the Southeast and in the South and the lower cost states. I think you continue to see in migration and real positive office fundamentals there. And by the way, we see that on the equity side of our business as well. I've mentioned this before, but -- and we've got a big portfolio of assets that we own in private funds and other investment vehicles that we own and manage and lease. And so a lot of the themes that we invest behind are similar. And so I think we still like office as long as a Class A. It's in growth markets. I think where we've seen its struggle as you start to get into more generic assets and some of the Northeast markets or the downtown markets. We're not exposed to many of those. But certainly would be a very, very high bar to lend on anything like that in today's market.

Looking at your investment pipeline, you raised some capital last week with a common stock offering. Can you talk about your investment pipeline. What the mix of assets looks like, kind of expected returns? Certainly, I'd expect it to be accretive if you're raising money, but would love to get your comments, Matt.

Yes. Historically, we've been very disciplined as we raise money. We've done it when it's really accretive to book value. This time we did, it was a little bit closer to book value, still above, but closer book value than what we've done historically. So it all comes back to where we can make these loans. And given what I described as the overall backdrop in the lending market, we felt it was a good time to kind of bring more capital into the company. Taking a step back, I think about what's going on in the lending markets right now, it started on the capital market side, where not through our publicly traded mortgage REIT, but we have private funds that invest in that. So again, it goes back to kind of the broader KKR lens and what we can see across the spectrum. But really in CMBS, single-asset, single-borrower CMBS, the way some transitional lenders finance themselves in the CRE CLO market. We saw a lot of weakness in the capital markets segment, beginning in beginning of the year into February and then certainly, obviously, as the war in the Ukraine broke out, and that's continued to today. And all these pockets of capital, capital markets, insurance, bank, agency, all this stuff is obviously interrelated and all that needs to work for the market to really function in a healthy way. And so I think with that volatility, you started to see a lot of volatility or more of a shift to lenders market in the transitional lending business. And that's really the backdrop to why we raised capital was that, okay, the market's shifting. There's more power in the hands of lenders today, again, lower leverage, more structure, more yield. We can target ROEs today well into the teens on some of the opportunities that we're seeing, so call it a few hundred basis points of incremental yield that we would have seen on lower leverage on better structure. So it feels like a really good time to lend. And at the same time, we're a larger loan lender. We make loans anywhere from $50 million to $750 million. And so when you think about the capital markets backing up a little bit, that's like right in our sweet spot where we're starting to see deals where historically they would have gone single-asset, single-borrower CMBS. Think about big portfolios of industrial properties to major sponsors relatively stabilized, good in-place cash flow, something that historically we probably wouldn't have been -- have went on the capital markets would have done it. And those are the kind of opportunities that we're seeing now. So I would say on the margin, if you think about us as our bread and butter is multifamily lending. And of course, we do other things, but we've shifted a little bit recently and tried to take advantage of some of these industrial portfolios that we're seeing or some of these bigger loans that don't have access to the capital markets right now. So sitting in that world and looking at all these opportunities, we went ahead and decided we would try to bring some capital in to take advantage of that.

Great. Switching gears a little bit to the financing side. So looking at your liabilities, KREF was one of the first in the sector really moved to a high mix of non-mark-to-market financing. Since COVID, you've really seen all of your peers kind of move up or move closer to where you are. Can you talk about, obviously, how that benefited you on the heels of COVID with the non-mark-to-market financing? But talk about the financing opportunities today with what's going on in the market, looking for non-mark-to-market versus traditional warehouse lines with counterparties, maybe an update on the financing markets today.

Yes. We always felt that the asset side, we knew what we were going to target, again, thematic investors. But we had to match that with the right liability stream. And historically, companies -- finance companies can get in trouble on the liability side. And so we've been very, very focused on creating liabilities that are diversified, are safe, and that basically means finding facilities that are non-mark-to-market facilities that when we make a loan, we know that we've got term financing for that loan until it repays without any ability to margin call us or for us to have to delever that financing. And so as you said, that we really have been the market leader in this space, not only from like just a percent of our portfolio that's financed on a non-mark-to-market basis. That's about 75% on average, today it's close to 80%. But also in developing new facilities, new investors, new technology that people can lend to us on a non-mark-to-market basis. And historically, the way most of our peers or competitors borrow on a non-mark-to-market basis is through the CRE CLO market, which is a wonderful market when it's up and functioning, however, in moments of volatility, you don't really have good access to that base of capital. So today, that pricing, well, you can still go get a deal done and there's people in the market issuing CRE CLOs and financing themselves in that way, it's just not very attractive. And so we use that as more of an opportunistic outlook -- outlet for us. And so when that market is open and healthy and functioning, we'll go take advantage of it. When it's not, what we do is leverage KKR and our capital markets team to help find partners that can finance us on similar terms, but just outside of a capital market, so bringing in insurance companies, banks that will do this on more of a bespoke transaction. And we've really developed a lot of facilities and a lot of relationships over the years that have really driven -- have really driven that liability stream for us. And it started out as defensive and we don't want mark-to-market, what it's become is offensive. Because in a market like this where all of our competitors have to finance or predominantly finance in CRE CLOs, well, we've got all these facilities that we've already put in place. We've got our financing locked in and we can go and really be aggressive in a market like this on the best quality real estate that we can and put it on these lines that we've developed over the last few -- handful of years, really.

Great. I want to talk about interest rate sensitivity for a second. KREF is effectively net long LIBOR given the floating rate assets and floating rate financing. The portfolio is now positively correlated with higher short-term rates. Can you talk a little bit about the benefits you expect to see kind of as we move into the second half and going forward, both from the increasing rates. Rates are now above the LIBOR floors on a larger percentage of your portfolio as well as expected repayments, pre-COVID loans that maybe have floors that are up in the high 1s or 2 handle. As those start to turn repay, should we expect to see an incrementally more positively correlation to higher rates? Maybe kind of talk us through that, please.

Sure. And just to give a little bit of background, the market generally sets floors around LIBOR floors or SOFR floors in today's market around the spot rate at that moment in time. And so when you think -- so think about us lending almost on a fixed rate basis with like no cap as rates go up, but a floor and a cap as rates go down or floor as rates go down. And so we had -- going into COVID, we had very high floors on our asset side, and none of our liabilities effectively had any floors. And if you want to put your kind of finance company hat on, when LIBOR collapsed, with the Fed moves, we made a very large returns. We had a huge NIM because our assets stayed where they were and our liability cost declined and we are -- I like to translate it into ROE or IRRs because that's kind of how I think about the world. We made a loan at a 12%, thinking we're going to make a 12% IRR, 13% IRR, we end up making like 16%, 17%, 18% IRR on those loans because of that dynamic with the floors and our liability is not having any. So beginning of COVID, we made -- you could go back and look at our earnings. We have huge earnings throughout that period of time, really excess earnings because we never expected to get those. And like you said, like we make short -- floating rate short-duration loans, business plans. Properties get leased, multifamily properties get leased and then they get stabilized and they get repaid. And so that percent of the portfolio has declined a lot. And so a lot of those floors are gone now. So now we're back to resetting floors, making a new loan today, loan pays off, we go make a new loan today, and we're resetting floors at the current base rate, which over the last year was close to 0. Obviously, it's increasing today and so we're kind of like inching back up. What that all means is we've now become -- the company is back to becoming positively convex to LIBOR, like our equity in our business is effectively a LIBOR or SOFR floating rate instrument. And so when you put all that together, it's a little bit dynamic because we'll continue to have those loans repay that still have high LIBOR floors. So we'll continue to get more and more asset sensitive or interest rate-sensitive, excuse me, over time. But if you kind of look at our portfolio as of the last quarter end, again, it'll get better, and you think about where the forward curve is, like 1 year from today, for instance, we could have our earnings increase by well over $0.20 a share on an annual basis. So we're just going to ride -- think about just ride the curve up as the Fed hikes. We're going to continue to benefit from that on all of our floating rate -- the equity base of our floating rate exposure.

Yes. The math behind that, looking at the forward curve is quite positive and likely to become incrementally more so as some of those older loans repay. I want to touch on the manager. Most mortgage REITs are externally managed, probably 75% roughly. KKR provides a lot of support and advantages. Maybe can you take a second and talk about the benefits you get from having a platform like KKR support KREF.

Sure. It's really hard to overstate the importance of living within the broader KKR ecosystem. They really -- it really helps, informs and we benefit from everything around us there. Number one, I would say, on the asset side of the equation, you think about the sourcing engine, the underwriting engine, the themes that we're investing behind is all informed by being fully integrated with our real estate equity team and we manage tens of billions of dollars on the real estate equity side of our business, thousands of units -- tens of millions of square feet of industrial. So we have lots of data points on that equity side that we can use and obviously, lots of contacts within the market that we can benefit from as we go to source and originate loans. On the liability side, I mentioned this earlier, but we've got a fully built out capital markets business within KKR, and that's when we go to finance our business, we are using them and leveraging all those relationships over the decades of -- 4-plus decades now of KKR has been a company to help deliver best-in-class liabilities. And then of course, we've got in a market like this. We've got a macro overlay as well so we can use our global macro team and we get as granular as using private equity team, for instance, like if we're looking at a life science property, well, we're going to go to our private equity team out in Menlo Park that buys life science and invest in that sector and get an understanding of the tenants and what they're looking for, any dynamic we need to understand in that space. So we're really trying to leverage the entire firm. And just so everybody knows, KKR is the largest shareholder in the company, and we will continue to do so. We recently did a secondary sale of some KKR shares that took us down to about 14% ownership and then we signed a long-term lockup for over 180 days and have been messaging to the market that this is our long-term hold in the company. So I think historically, there's always a little bit of overhang. KKR gave us a bunch of capital, help start up the company 7 years ago and 5 years now as a public company, but -- and has been transitioning some of that capital back and into new investments, and now we're kind of done with that transition period. And we're at a base now where we'll again continue to be the largest shareholder in the company with about 14% and continue to benefit from all those resources I described on originating and underwriting and liabilities.

Great. Running a little ahead of time, so I'm going to squeeze an extra question here. But when you look at the outlook, forward yield curve now has an ease and a cut in late '23. When you think about the economy. How is portfolio performance -- how have you changed underwriting for new loans as you think about portfolio performance going forward? You mentioned earlier around multifamily, LTV is a little lower than maybe what it's been historically. So it seems like you guys, in a less competitive environment, have been able to be a little more conservative underwriting, but maybe go into a little bit about your outlook on performance and maybe how you've tweaked underwriting standards for new things you're doing today.

Yes. I mean as this particular audience, I think we're all really aware of some of the dichotomy that's happening in the market in terms of like we're all looking at real estate performance, multifamily and industrial and all things, housing and seeing really strong performance on the ground, structurally full markets, a lot of positive momentum in rents. And we're just trying to understand what that all means as it relates to higher financing costs, more geopolitical uncertainty and trying to, I guess, where does all that land. And I think what it brings us to locally here is like we said, it's -- we're certainly getting more structured with that higher financing costs, more uncertainty, we do think values are declining in the [indiscernible] equity markets. And so we're lowering our leverage to make sure that we're at a -- continue to be at a very safe point with from the capital structure. And I would say we're also pacing as well. I mean I think this is a market where you're going to have opportunities over time. It's very different than how we approached, I would say, the beginning of the pandemic where almost every part of KKR Real Estate Credit, real estate infra, PE, corporate credit, energy, we were really kind of like pushing almost every chip we had into the market and trying to invest in that late spring into the summer and fall. I would say we're approaching it very differently now. We're in a new paradigm as it relates to Fed activity. And for many of us, we're in a new paradigm investing in a bear rates -- what could be a bear rates market. And so I think we're just mindful and respectful of what the broader markets are telling us, even though locally here, we really like the real estate setup. We really like the real estate lending setup right now, but I think you just got -- you got a pace appropriately and make sure you've got a lot of in the system. And so when you think about what we've done kind of -- take these broader investment comments that I just made and put them aside and put your KREF hat back on and like what are we doing for KREF, I would say a couple of things. Obviously, we raised equity into the company to help take advantage on the kind of offensive side, if you will. But on the defensive side, we've also increased our liquidity from -- for instance, we added -- increased the size of our revolver and extended the term of our revolver from around $335 million to $600 million -- over $600 million in the last quarter, which gives us kind of $600 million of liquids at a base of $1.7 billion of equity. So that's a lot of liquidity and capital we can draw into the system if we ever needed it for any reason. And so I think we're trying to just balance that and we've reduced leverage in the company as well, where we typically would run high kind of 3x debt to equity, we're mid- to low 3s at this moment in time. So some of these liquidity things, some reducing leverage, but also continue to pace and make new investments as we see fit.

Great. I want to give an opportunity to audience to ask questions if we have any today. All right. Well, with that, Matt, I guess we've covered a lot in a short amount of time. So in closing, maybe can you leave us with what you are most excited about for KREF over the balance of the year and maybe what should we as investors and the public markets look at most closely to really see you guys separating yourselves and distinguishing yourselves from your peers kind of as we watch performance in the coming quarters.

Yes. I think that where we've had success historically will continue to drive our performance, and that's really been around -- in my mind, it comes down to quality. On the asset side, we have really focused on high-quality real estate, and we've been, again, very thematic investors, and we picked the right themes around -- especially around the multifamily. And so you think about making an investment in a world like we live in today, and you can invest in a mortgage REIT that's lending on really high-quality assets in the 60s, portfolios in the 60s. Loan to value, you've got a huge cushion for any potential declines in equity values. It's financed in a way that's very safe. You've got positive exposure to increases in interest rates. Inflation is not a bad thing for us. We're going to benefit in our earnings, and it's going to making replacement costs go up. And so that should help our loan to value over time. And so the fundamental setup, I think, looks very good. There's kind of embedded growth. There's embedded stability, there's embedded safety. And then, of course, you've got a manager externally managed by KKR, who is the largest shareholder. So if you want skin in the game, and I would say that's obviously a really important aspect as well. And then we've got all these data points that we can use, again, whether it's in the credit side or the equity side -- real estate equity side of our business to help inform how we're making new investments going forward and adjusting to kind of the realities of what we're seeing on the ground.

Great. Well, Matt, thank you very much for joining us today to the audience. Appreciate your time and listening in on the KKR Real Estate Finance comments today. Thank you.

Great. Thank you very much.