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

Thank you so much for joining us this morning. I'm Ricardo Chinchilla. I'm Deutsche Bank's Financial and Fintech High-yield Analyst. Today with me, I have the pleasure of hosting Patrick Mattson, the President and Chief Operating Officer of KKR Real Estate. Thank you so much for joining us in our conference.

Thank you, Ricardo. Thanks for having me back.

Perfect. I wanted to start with a quick background of KREF. And you could also spend some minutes talking about the transitional CRE lending market, that would be grateful for our audience.

Great. Certainly. So from a KREF perspective, KREF is coming up on a 10-year anniversary. Our credit business was started at the beginning of 2025 (sic) [ 2015 ] and KREF was started originating in that year as well. So it's obviously a milestone year for us. KREF is focused in the large loan transitional space. By that, I mean loans generally that are $50 million to $500 million in size. Our average balance is north of $100 million. We're focused on an institutional quality real estate. So if you look at our sponsors, our assets, they tend to be of institutional quality in the largest markets predominantly Class A real estate. Our focus is on the asset classes that I think are very much aligned with what our equity business focuses on. So you'll see heavily weight toward, in particular, multifamily and industrial, some student housing, and we'll also participate on the office and hospitality side. From a profile standpoint, if you look at our assets, you'll see that they're light transition. So by that, I mean, generally, the sponsors are focused on transitioning that asset, I mean this pre-stabilization period to stabilization, predominantly through lease up. So there's not a lot of heavy focus on construction or redevelopment, it tends to be more focused on lease-up. So the time to execute the business plan tends to be shorter than, I would say, most transitional loans. Within the transitional lending space, we think it's a very interesting time to be active in the space. We've seen over the course of the last 12 months, and I think will continue to persist in the near term, we've seen the banks pull back, in some case, in a fairly meaningful way that's creating more opportunities for nonbank lenders. And so when you think about the type of capital that we have to deploy, we're very excited about the opportunity set. Clearly, values have started to reset. We're in a rate complex that is now a bit more constructive for sponsors. And so we're excited about the opportunity over the next 2, 3 years to deploy capital.

Perfect. I was hoping if you could comment on the benefits of operating under an externally managed model and the KKR sponsorship.

Well, it's hard to overstate the benefits that we're deriving from being part of a larger global asset manager. That's everything from sourcing to underwriting to how we finance assets and asset management. Each part of our business is impacted in a positive way through our affiliation with KKR. Clearly, we're part of a broader real estate franchise. We're driving a lot of benefits by working side by side with that team. So whether it's sourcing new deals, getting a look on transactions that might be in the market before some of our peers do, being able to really tap into the knowledge base that we're developing on the equity side of the platform. We've got an enormous multifamily and industrial portfolio in almost every market that we are active on the lending side. We have some corresponding exposure on the equity side, and that knowledge and information share is really powerful. And I think we do that mindshare as good as anyone out in the business, and that's a really powerful tool. The other area where it shows up a lot is on the liability side of what we're doing. We, over the last to 6 years, have really focused on diversifying our liability structure. Clearly, things like the Term Loan B are a part of that, but also a number of bespoke non-mark-to-market facilities that we've created. We've created that by leveraging our KKR Capital Markets team, which we call KCM. And we've been able to create structures that are bespoke in the market that have allowed us to finance these assets on a non-mark-to-market, match-term basis. There's readily available repo facilities in the market, and we do utilize those facilities. We've got a lot of great bank relationships and great bank counterparties there. But having that diversity has been key, and we've seen lots of examples of that through the onset of COVID up to today, where having that diversified non-mark-to-market financing strategy has really paid off. And last here, I just sort of mention is the only asset management front and the technology. The information that we're able to bring to bear as a group and the way that we're harnessing that, it's been an important part of the business over the last couple of years, as we further spent a lot of resources to build out this platform and the technology infrastructure to really allow us to manage our assets efficiently. And we think over time will lead to differentiated results.

Perfect. I was hoping if you could give us some color on KREF's investment strategy and how the company offers value in the real estate life cycle.

Sure. I think the value proposition that we offer to the market is the fact that we have this integrated platform. So as we are approaching our clients, our institutional clients, we can approach it not just from a lending mindset, but really bringing the knowledge that we have around the market, around their needs from our equity side of the business. And I think that's one of the differentiated outcomes. I think another area is that as we've grown the platform over the last 10 years, we've expanded beyond KREF as the publicly traded mortgage company into capital now, that is insurance capital. KKR owns Global Atlantic. Our group is investing on behalf of that capital. We have private debt funds. And so we are very active in the market. And as we're approaching the market, really bring kind of a full wing-to-wing set of capital. So depending on what the needs of our sponsors are, we generally have a solution that we can provide. That provides a lot of synergies for the mortgage REIT because it means that while we might be working with the sponsor on something that's fixed rate financing or one of their stabilized assets, we're building that relationship and able to leverage that when we might want to do or they might want to do something that is a bit more of a value-add or a pre-stabilized transaction. So that connectivity to the broader market that we're able to derive from the scale of the business has been super impactful.

Perfect. At the end of the second quarter, the average risk rating of the company's portfolio was 3.1. This represents actual improvement versus the first quarter where it was at 3.2 and the company was monitoring 5 watchlist loans, right, including 1 office asset. What percentage of the CECL reserve that KREF allocate across the 5 watchlist loans versus the other parts of the portfolio? And when you look at the 5 watchlist loans and the 4 real assets, which of those may have a resolution in the second half of 2024?

Okay. I'll try to tackle all of those there. Thank you for the question. As you might expect, from a reserve perspective, the reserves are heavily weighted toward our watchlist assets, our 4s and 5s. The model for the performing loans is just that it's sort of model based. And the way that CECL works is that every loan gets attached some form of loss even if our expectation is that these loans will sort of pay out over -- pay out at par over time. But as those loans end up on the watchlist, in particular on the 5 rated assets, there, it turns into a bit of a more manual control, and we can hone in on what we think value is and take appropriate reserves specific for that asset. So it's a good majority of our CECL reserve is allocated towards those 4s and 5s. So it's a big chunk of that reserve. I think in terms of your second question on resolution timing, they will -- all these assets are unique in terms of how they will likely get resolved over the next couple of years. I think we've got a lot of tools at our disposal, again, given our broader connectivity with into the firm to manage these assets to the appropriate outcome. Some of these watchlist loans are going to get resolved through the modification where the sponsor is putting additional capital in, and we're modifying the terms of the loan. Others, we might see resolved through an intermediate step where we actually take the asset back, work that asset, look to get it leased up in the market and then monetize it at that point. And so while I expect that we'll see some resolutions in the near term, other resolutions are going to take out or going to take several quarters to years to sort of play out. And again, there's different ways to resolve these assets. Our goal in sort of resolving each of these is trying to figure out how do we best preserve book value, how do we best maximize present value of this asset, and that's going to take us down different paths. And so we don't have to just sell the asset at today's spot market, we can actually add value to the asset, improve the real estate and then monetize those assets at better times as we work through the watchlist.

When you were responding to my first question, you mentioned that normalizing transaction volumes and low bank participation would create an attractive opportunity for the company. I was hoping if you could provide more information on how the company would move to offense to make the most of these opportunities.

Yes. Good question. I think the market dynamics are such that they're setting up very well for lenders like us in this space. And by that, I mean just to delve in a little bit deeper, we're seeing a pullback on the bank side to making direct CRE loans. I don't think the banks are actually in the business. But given the size that the banks have historically represented, even a modest pullback represents a pretty sizable amount of origination volume in any given year. What we're also seeing, at the same time, while the bank's transition some of their capital away from the direct lending is more capital being allocated toward financing of the types of loans that sort of -- that we're making. So we're seeing more interest whether it's repo or warehouse financing or loan on loan structures, seeing more interest from the banks to finance counterparties like ourselves, it's better capital treatment. If you look at this past cycle, we're going to see a lot better performance on this book of business in the banks versus some of the direct lending. And so I think there's going to be increased and we're seeing it today increased appetite for banks to participate in that form. KREF and a lot of peers that look like KREF on both the public and private side will be a prime beneficiary of that. Additionally, what we're also seeing is historically, that financing came on mark-to-credit or mark-to-market terms. We're seeing more banks provide that capital in a non-mark-to-market term. How are they getting comfortable with that? I think one of the reasons they're getting comfortable with that is if you look at the way these facilities are structured, they are generally multiple assets on the facility. You're not really tied to the performance of one asset. And so they almost function as a mini CLO or a private CLO for the banks. And like I said, the performance is going to -- the performance along with the credit treatment to drive increased participation on that front. So KREF is poised to benefit from that shift that's happening in the market. We're also at a point in the cycle of the business where, as we've described it, we may not be out of woods, but we're certainly on the edge of the woods. And as we think about some of the capital that we're getting back now in the form of repayments, that capital, we can almost think about as excess liquidity, and we're in a position where we can start to redeploy that capital into this environment into new loans. So from a mindset perspective, we're certainly geared more toward the offense than we are in defense as we work through some of the watchlist loans.

Perfect. Would just talk about the opportunities in the current market environment? And will you also talk about what is the most significant challenge for KREF in this market?

One of the challenges for KREF and for public vehicles like this is some of the pro-cyclical nature of the capital. I think as we look over the next couple of quarters and into the next couple of year, the lending environment looks very attractive. We've seen values reset. We're able to get better structure at lower leverage levels and still generate comparable returns to what we've been able to generate over the last 4 to 5 years. The dynamic sets up well. I think the headlines in the industry in the near term are going to continue to be a bit negative. We're going to see increased multifamily foreclosures, office will continue to be a drag and in the news and in the headlines. And so that's a little bit of the challenge for us in this market, while we might see a very attractive lending market I think sort of the broader headline on the broader picture on CRE is going to be a bit more mixed. And so I think as investors start to dive into these specific names and the opportunities, I think we're going to see more capital come into real estate credit in general. That is starting to happen. But I think it's still -- I think the headlines are still going to be a challenge.

Perfect. I was hoping we could discuss the company's medium- and long-term leverage targets.

Certainly. So we've historically targeted 3.5 to high 3s leverage. That's a total leverage level. We also report a debt-to-equity ratio, which excludes some of our nonrecourse financing. On a look-through basis, we've sort of been at this 3.5 to high 3s target. We saw pick up a little bit over the last year as we increased reserves, some realized losses that is now through repayments and some de-leveraging, dropped down back below 4x leverage. And so we're back into that ZIP code that we're targeting. I think it's important as you're looking at these companies to not only look at that target leverage ratio, but really kind of take one step further and look at those underlying assets because if you look at the way that we've tried to position the company on the asset side, our focus tends to be on a bit lower leverage on more stabilized type of properties or pre-stabilized assets. So we're in kind of a light transitional as opposed to heavy repositioning. And so our focus is to take lower asset risk, but finance that at a moderate but sort of prudent amount of leverage that's diversified over a number of sources. So we're in that target range, we're operating in that target range and would expect over the near term and intermediate term that we continue to operate right around that level.

Perfect. I was hoping if you could comment on the company's capital allocation priorities.

Certainly. So in terms of allocation priorities, clearly, we're a lender in this space. Our focus is trying to find good risk-adjusted returns in the direct lending space. As I said earlier, we're -- in one of those moments, we're in that sort of part of the cycle where you want to be a lender where values have reset, where you're getting paid well for the risk that you're taking, and if you look at where the index rate is, albeit they are coming down, still able to produce a very healthy levered return. So our focus clearly will be on the lending side. The other area that is -- that we'll also consider and if you look at our history since we've been public, is share buyback when we've traded at a discount, clearly, at times, that's probably our best use of capital is to buy back shares. But ultimately, we want to expand the company. We want to be able to expand our sponsor base, and we want to service our clients on the lending side. And so we're very keen to, as we're deploying capital, focus on those areas. We'll continue to be focused on those primary areas where we're overweight today, multifamily in industrial namely. But really, all things on the residential side look relatively interesting. And so continued sort of focus there. I think opportunistically, we look at things on the hospitality side. We'll look at things in the life science sector where we have some exposure. That market is going through some cyclical challenges, but clearly it doesn't have some of the secular headwinds that the office market has. So in the near term, we'll be focused on those main areas. I think over time, there is going to be compelling office opportunities. I think as a public company where people look at some of the headlines and look at those exposures, it's hard at this point in the cycle to necessarily increase that office exposure. So we'll obviously need to be mindful of that. But the market will create some very interesting opportunities in the office segment, which will be really defined by sort of the haves and the have-nots. And so even in the haves section, you'll find some compelling opportunities. But in the near term, I would look for us to do a lot of the same that we've been doing. And as we're looking to grow the portfolio, we'll continue to want to access various parts of the capital market structure. In the past, we've been a converted issuer. We have the term loan B. That's an area that we would like to continue to grow over time and we continue to monitor the unsecured market as well and think as the company continues to grow, we expect that to be a part of our overall financing strategy.

I was hoping if you could give us some insight into the M&A environment in the space and if the current market conditions should result in more opportunities out there.

I think as we look out over the next 12 to 24 months, I do expect we'll see M&A activity. I think we'll see activity for portfolio transactions, which can also be a catalyst for sort of growth in this market. You're already starting to see some bifurcation in the market in terms of where some of the public companies trade. I think the market probably needs a little bit more clarity on where some of the book values end up and where some of the watchlist loans on various portfolios, how they get resolved before you can really have good price discovery and see potential transactions. But as a company, we are open to that. And I think as a market, we're going to see likely some consolidation over time.

Perfect. I've been telling CEOs these past few days that we analysts, we like to be scared of something, right? We were scared that the Fed was not going to do cuts this year, and that didn't happen. And now we are scared that we are entering into a domestic recession. Are you -- is there something that you are concerned about in this market environment? Is there something that is keeping you awake? How you feel overall?

Well, generally, I sleep pretty well at night. So I don't think there's too many things that are keeping me up at night these days. I think perhaps an obvious point, but I do think the -- as I think about some of the outside risk, geopolitical or otherwise, those are the types of things that give me more concern. When I think about real estate and just the real estate fundamentals, absent, as you said, sort of a major recession, which is not what we're forecasting, I think the fundamentals line up pretty well. This tends to be a cyclical business, and we're coming out of this cycle now. As I look over the next couple of years, there's a lot to be enthusiastic about, both on the credit side and the equity side of real estate. So I think if there were some concerns, it's concerns that are going to come outside of the real estate market.

I was hoping if you could give us some insight on how your discussions with the rating agencies have evolved over the last 12 months and if you keep a constant engagement with the rating agencies.

It's a great question. Yes, we do have fairly regular dialogue with the agencies. I would say that they have shifted as you might sort of expect over the last 12 to 18 months, I think as we sort of started this cycle and as we saw some of the defaults and valuation decline and sort of repayment sort of slow down, I think the area of focus for the agencies was on liquidity and do these companies have enough liquidity to manage through. And I think that's an area that we've been highly focused ourselves as a company. And this is where we also have, I think, a very differentiated edge. We've got a corporate revolver, that $610 million of capacity, a very unique piece of paper relative to our peers that we can use for any general corporate purpose, that's provided us a lot of stability and a lot of liquidity as we've been sort of managing through what's been sort of a challenged couple of years. The shift is focused away from liquidity, I think, to asset performance. And so a lot of focus now on resolutions, getting through sort of the watchlist, what happens to book value and sort of focus on leverage, right, at these companies. I think what we will start to see and hopefully the agencies will start to take into account is we are seeing real improvement across all of those parts of the business. From a liquidity standpoint, we're seeing repayments that even absent capital markets activity is creating liquidity for companies, certainly for our company. We're seeing improvement on the watchlist and resolutions on these watchlists where, again, I don't think we're out of the woods yet, but it does feel like we're in a bottoming process where as we look at our book, we have our watchlist loans. We don't see a lot of new stuff that necessarily is going to make it to the watchlist. So that's encouraging. And I think the agencies will start to take note of that. And then I think, lastly, as we start to see redeployment in the space, and we see a return to offense. I think that's going to be a signal in some way for the agencies to reconsider or reevaluate how they're thinking about these companies. Clearly, if you're looking in the rearview mirror, you see a lot of choppiness. But if you're looking forward, actually, it's -- seas get a little bit more calmer and the opportunity set gets a little bit better. So I think that will start to get recognized, and I expect that we'll start to see that through the ratings actions over the next 12 months as well.

Perfect, talking about your capital structure, do you anticipate any change between the mix of your fixed and variable rate over the next 12 to 24 months?

Not anticipating that our assets are all floating rate. And so our focus historically has been kind of matching our liabilities in a floating rate fashion as well. It's not to say that we can't take on a component of liabilities that are fixed rate. And I would suspect, again, as we're able to grow the portfolio and grow the company that having some fixed rate exposure does make sense. So it's an area that we certainly will think about exploring. But in the near term, I expect that we'll continue to focus on making sure that our liabilities and assets match from an interest rate perspective.

This has been a great conversation, but unfortunately, we run out of time. I appreciate the you are coming to our conference, and we hope to see you next year.

Right. Well, thank you for having me, and thank you guys for joining.

Thank you so much.