KKR Real Estate Finance Trust Inc.

Good morning and welcome to the KKR Real Estate Finance Trust Inc. Third Quarter 2020 Financial Results Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Michael Shapiro. Please go ahead.

Thank you. Welcome to the KKR Real Estate Finance Trust earnings call for the third quarter of 2020. We hope that all of you and your families are continuing to stay safe and healthy. Today, I am joined on the phone by our CEO, Matt Salem. our President and COO, Patrick Madsen, and our CFO, Mustafa Migati. I would like to remind everyone that we will refer to certain non-GAAP financial measures on the call, which are reconciled to GAAP figures in our earnings release and in the supplementary presentation, both of which are available on the investor relations portion of our website. This call will also contain certain forward-looking statements which do not guarantee future events or performance. please refer to our most recently filed 10-K precautionary factors related to these statements. Before I turn the call over to Matt, I'll provide a brief recap of our results. For the third quarter, we had a record gap net income of $31.4 million, or $0.56 per share, which included a $0.1 million benefit from a lower CECL provision. Core earnings this quarter were $32.5 million, or $0.58 per share, driven by the continued strong performance of our portfolio and the significantly in-the-money LIBOR floors. One change to note. As per SEC guidance, beginning with our fourth quarter results in early 2021, we will begin reporting core earnings inclusive of the change in the CECL provision. Consequently, we will recast prior quarter's results to reflect the change in presentations. Please note that had we adopted the aforementioned change in presentation, core earnings per share this quarter would have benefited by one penny and been 59 cents per share. Post value per share as of September 30th, 2020 increased to 1873, which included the impact of $1.16 per share from CECL as compared to 1857 as of June 30th. Finally, I would note that in mid-October, we paid a cash dividend of 43 cents per share with respect to the third quarter. With that, I would now like to turn the call over to Matt.

Thank you, Michael. Good morning, and thank you for joining us today. We hope you are all healthy and safe. We had a strong quarter on many fronts. We continue to see the benefits of our company's conservative positioning and on both our lending strategy and liability management, which has allowed us to differentiate ourselves during this volatile market. Since the onset of COVID, we have maintained a best-in-class portfolio comprised of $5 billion of lighter transitional floating rate senior loans with a significant overweight to multifamily and office properties. and only 8% exposed to hospitality and retail. Increased our market leading fully non-mark to market financing to 78% in order to further de-risk our liability set. Increased our liquidity position through the inaugural issuance of a $300 million term loan B, which enables us to take advantage of the current lender friendly market all while delivering record quarterly earnings, which has benefited from net interest margin expansion resulting from our strategically negotiated in the money LIBOR floors. As of September 30th, our portfolio balance was approximately 5 billion with only 462 million or 9% of total commitments for future funding obligations. Our almost exclusive senior loan portfolio focuses on institutional real estate and sponsorship and is secured predominantly by Class A, lighter transitional, multifamily, and office properties in the most liquid real estate markets. Our average loan size is $135 million, and approximately 80% of our loans are secured by properties located in the top 10 markets in the United States. Our investment portfolio is 99% senior loans with no direct holdings of securities. As I mentioned, our two largest property type exposures are multifamily and office, which represent 83% of the portfolio collectively and have a weighted average occupancy in the mid-70s. In addition, 86% of our multifamily loans and 75% of our office loans are secured by Class A properties. underlying tenant collections have been consistently high. As a reminder, none of our office properties are located in New York, San Francisco, or Los Angeles, markets which have seen significant increases to co-working tenants in recent years. Over 99% of our collections are current through October. Through our robust quarterly asset review process, We reevaluate every loan in the portfolio to assign an updated risk rating. Our portfolio has a weighted average risk rating of 3.1 on a five-point scale, consistent with the weighted average risk rating at June 30th. Eighty-four percent of the portfolio was risk-graded three or better, and we feel confident about the performance on those properties. We don't anticipate much transition in our ratings in the near term. As we did in the second quarter, we provided a detailed breakout of our watch list loans in our supplemental presentation. We feel good about our position in many of these properties and are seeing improving trends in a number of business plans. However, we haven't been completely unimpacted. As we have previewed prior, our Portland retail property is most negatively exposed and was downgraded from a four rating to a five rating this quarter. While this loan is current as of October, we expect to be entering workout discussions given the pending maturity. We believe we have adequately reserved against any potential impacts from this loan through the CECL evaluation process. For the second straight quarter, we are beginning to see some signs of normalcy in the broader market, both from an origination and repayment perspective. Starting with repayments, during the quarter, we received approximately $274 million of repayments, including an approximately $30 million pay down on one of our New York condo inventory loans. Subsequent to quarter end, we received an additional $65 million of repayments. It is always difficult to accurately predict repayments and even more so in this market environment. But as a reminder, we have several loans in our portfolio near or at stabilization. On the origination side, while we didn't close any new loans prior to quarter end, we did close three transactions in October. With many lenders on the sidelines, we were seeing a favorable market dynamic resulting in better credits and opportunities to create net interest margins in the mid to high 100s as compared to the low 100s earlier this year pre-COVID. Let me spend a couple of minutes providing incremental details on our recently closed deals. All three are good examples of our return to market and continued focus on the same high-quality real estate we have been underwriting since our IPO. Additionally, they highlight the benefits KREF receives from being part of a leading global alternative asset manager and a growing real estate platform. As you may have noted, KREF co-originated these transactions with other KKR private strategies. KREF is our flagship transitional senior loan strategy and has priority over these investments. But at times where it makes sense, we will share risk dependent on factors such as the timing of commitment, the loan size, and KRF's liquidity position. The first two examples are similar to the loans we were making pre-COVID, refinancing newly delivered luxury Class A multifamily buildings, and markets with strong underlying demographics. Our loan provides our sponsors a better cost of capital and time to lease the property and burn off the initial lease-up concessions. Both properties had commenced leasing, and there were no moving pieces as it relates to construction. We were able to underwrite recently signed leases and extrapolate into a stabilized cash flow, leading to a straightforward underwriting on a simple business plan. In a notable transaction, KREF co-originated a $509 million whole loan, with KREF committing $160 million to a leading real estate development company in the San Francisco Bay Area to acquire and renovate a 1 million square foot Class A office in Oakland, California. We are executing a senior loan sale of approximately $135 million to finance our retained $25 million piece. This financing is a great example of the benefits of having access to a broader asset management platform, utilizing the full KKR brain to lend on high-quality, well-located real estate. The best examples of this are from a sourcing perspective, it was an institutional sponsor that was an existing JV operator for our real estate equity team. From an underwriting perspective, effectively single tenant asset that our corporate credit team was already familiar with and had underwritten. And we had local market knowledge. where KKR Real Estate owns office properties. Finally, from an execution perspective, we work closely with our capital markets team to speak for the whole 509 million while having line of sight on the sale of the senior portion to generate an attractive return. Our forward pipeline remains strong with several loans under exclusivity which are expected to close within the next few months. You will continue to see us focus on investing in defensive property types, in liquid markets, and with top tier sponsors while maintaining our focus on capital preservation. Sitting within the broader KKR platform gives us a unique perspective and a look into risk adjusted returns across asset classes. The combination of KREF's in-place portfolio, our cost of liabilities, and the additional new loans underwritten in today's environment, we believe are delivering attractive risk-adjusted returns relative to other yield proxies. We're excited about our franchise and our competitive positioning in the market and the continued growth opportunities for KRF for the remainder of 2020 and going into 2021. Now, let me turn the call over to Patrick.

Thank you, Matt. Good morning, everyone. I hope that you continue to stay safe and healthy. As of quarter end, a market leading 78% of our in-place asset financing was completely non-market to market. And the 22% remaining balance was only subject to credit marks. We continue to invest a considerable amount of time and resources across KKR, differentiate and diversify our financing sources. And in September, we were excited to close our inaugural term loan B issuance. The proceeds from the $300 million seven-year loan allow us to take advantage of the current lending opportunity as well as continue to reduce some of our mark-to-credit facilities. Additionally, the pricing flexibility of the Term Loan B affords us the ability to adjust the cost of capital in the future to match the conservatively positioned profile of our assets and other liabilities. Our intense focus on non-mark-to-market financing has allowed us to lower the risk of our liabilities, while at the same time maintain target leverage levels despite the volatility this year. As of quarter end, our debt to equity ratio and total leverage ratio were 1.9 times and 3.8 times respectively, down from the second quarter. As a reminder, we have generally targeted a three to four times leverage ratio on new senior loans. depending on the source of financing. While we've been willing to finance loans at a low 80s advance rate on our non-mark-to-market financings, we would expect our total leverage ratio to gravitate more toward the mid-3s in the coming quarters. Our repo financing, which currently represents only 22% of our outstanding secured financing, is diversified across three banks. and currently has a weighted average advance rate of approximately 65%. The repo facilities finance 10 loans predominantly secured by Class A multifamily and office assets. Notably, we have not received any margin calls on these mark to credit facilities. KRF's liquidity position remains very strong with over 700 million of availability including cash of approximately $300 million as of 3Q and access to an additional $335 million for our corporate revolver. While we have currently earmarked some of our liquidity for our increasing pipeline of loan opportunities, given the level of uncertainty in the markets, we do expect to hold incremental cash on the balance sheet versus prior years to maintain flexibility for the foreseeable future. which could create some incremental drag on earnings. Additionally, as we started to see in the third quarter, a higher rate of repayments and timing mismatch between repayments and new originations may add to our liquidity position in the near term. Finally, almost the entirety of the portfolio remains invested in LIBOR-based floating rate loans. 98% of the loan portfolio has a LIBOR floor of at least 95 basis points, while only 2% of our liabilities, excluding the new term loan B, have a LIBOR floor above zero. So with spot LIBOR averaging 16 basis points for the third quarter, our rate floors were almost entirely optimized for the full quarter, providing a significant earnings benefit. For further context on the benefit, since the beginning of 2020, one month LIBOR has decreased 160 basis points. During this same period, bolstered by our rate floors, our loan coupons have only decreased 20 basis points, from 5% to 4.8%. At the same time, the decrease in LIBOR has dramatically reduced our liability cost. resulting in an expansion of our effective net interest margin by 130 basis points to a level above 180 basis points on our direct secured borrowings. As we experience a rotation in our portfolio through loan repayments and new originations, we expect the NIM to compress over time. In summary, Our best in class investment portfolio is providing strong earnings power through loan performance and significant in the money rate floors. We generated record net income during the quarter. We continue to diversify our financing sources, including growing our market leading 78% non-mark to market secured liabilities with the issuance of the new seven year term loan B. We have a very strong liquidity position. allowing us to return to the new originations market, lending at attractive levels on credits consistent with our historic underwriting. Thank you again for joining us this morning. And now, we are happy to take your questions.

We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the key. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. The first question today comes from Dave Romani of KDW. Please go ahead.

Thanks very much. Can you give some color as to the types of deals you're seeing and You know, what the sponsors are looking to achieve, you know, if there's been any changes in the way they're underwriting deals. I noticed one of the deals had below a 50% LTV. Just some color on the transaction market.

Hey, Jade, it's Matt. Thanks for joining. I'm good to hear you. Yeah, it's a little bit of color. We're seeing the market slowly reboot here. And obviously, we're starting to take advantage of that. I would say all-in coupons are in the 4% to 4.5% range for the higher quality assets. And there's real bifurcation, I would say, in the market today between the have and the have-nots. So clearly, you can understand hotels and other sectors that have been the most impacted The financing there is much more difficult and coupons much wider there. Where we've been focused historically, so I don't think we've really changed our credit DNA at all. So really trying to focus on the multifamily sector of the market and then well-leased office. What's a little bit different now is Two things. One, it's more of a lender's market, as you would expect. So you get better structure, better credit, in some cases, lower leverage. Obviously, the all-in coupon is similar to what we were lending at pre-COVID, but the composition has changed quite dramatically given where LIBOR is. So the spread is very high. And the overall MIM, as we mentioned on the calls, has increased from low 100s to very high 100s. And the other thing I would say is that the fact pattern or the business plan that you're lending on is a little bit more advanced. And so, for instance, if we were making a multifamily loan pre-COVID on a construction takeout lease up, that property may have been somewhere between 10% and 30% occupied. So some of the opportunities we're seeing today are more 50% occupied or higher. And clearly there's going to be a range, but And what the sponsors need is just more time, right? Everyone's trying to buy time. And so I think that the traditional segment of the market will continue to have a lot of opportunities to lend as sponsors just need to, you know, their business plans are all elongating, whether that's, you know, any type of lease up. And so they're just going to need to, you know, to buy that time and get new financing that allows them to, you know, effectuate that business plan.

Turning to the office sector, are you seeing any broader changes in the way either sponsors, lenders, or the market overall is looking at office space? I think that pre-COVID, the average office lease was somewhere in the 8.5 to 10-year range, and there is some chatter about typical lease durations being curtailed. JLL's CEO said that in the second quarter, the average lease deal had 16% shorter term Um, you know, how are you thinking about that or what are you seeing with respect to the office market?

Yeah. Um, well, so I put, I think everyone puts office in this category of a, it has a big question mark around it. And, you know, in my mind, um, it was a real cyclical issue with office. I mean, you never want to lease up office in a, in an economic downturn. Um, and then there's the secular question that we're all debating, um, around usage going forward. changes in behavior. So I would say given those are both at play, both the secular and the cyclical, I think we're very cautious right now on the sector overall. We don't have enough data points to answer your question directly. Our lease is getting shorter. I would say as we're underwriting new office loans, we want higher occupancy, longer leases, more stability, and we're still taking a lender's view and protecting our downside. But I don't think the market's evolved enough to really tell you this is exactly what we're seeing in terms of shorter lease terms. It certainly wouldn't surprise me. But again, I'm not sure that's a secular issue or a cyclical issue.

Okay. Turning to the Portland asset, you said that you feel adequately reserved uh with respect to your basis um and the cecil reserve you know what are you looking at the outcome in a workout is this going to be essentially a foreclosure whereby kref takes control of this asset and figures out a repositioning strategy um would you bring in you know third-party capital for this and just directly you know what impact will this have on the company's liquidity I believe this asset is not financed on any repo lines, so it probably will have a minimal impact on liquidity. But if you could just touch on that.

Sure. I think it's too early to tell on how exactly the workout proceeds. We have a sponsor in place still that's kept our loan current. And so we'll be working with them on what the business plan is going forward and I think it's too early to speculate how this may play out. Patrick, I'll turn it over to you for the liquidity perspective. But overall, it's not a big position, obviously, for us. And we have as much liquidity as we've had in the company. But Patrick, do you want to give any specifics?

Sure, Jay. Just to follow up on that. So we've got a small amount of leverage against this, something on the order of you know, less than 20% of the face amount of the loan. So not a big mover in terms of our liquidity usage if we decide to pay off that financing.

Thanks very much.

Next question comes from John of Wells Fargo. Go ahead.

Good morning. So look, I mean, it's good to see you guys holding your own in a difficult market. I was wondering, Matt, if you could just provide an update on some of the other watch list assets, in particular the New York condos and then the Fort Lauderdale Hotel.

First on the New York condo hotel, this is an asset that, over the last couple of quarters, we've actually seen an increase in sales. So both in the second and the third quarter, we saw three units sell in each of those quarters. And there's an additional unit that sold and closed here in the fourth quarter, which will get reflected when we report next quarter. I think we've been pleased with the progress of the pay down. Those sales for context have been in the $2,200 a foot range. And for context, our loan is around $1,720 a square foot. And so from a basis standpoint, we feel good. We like the velocity on those sales. And the amount of leverage that we have, similar to our Lloyd asset, is really a fraction of our outstanding loan balance. So in total, we've had about 41 million of pay downs these last two quarters. On the asset in Florida, we continue to work closely with the sponsor. As you recall, this is an asset where we've entered into a partial forbearance on the payment in exchange for some cash that came in from the sponsor. That partial forbearance period extends for several more months. And we've seen some improvements in terms of the occupancy of that asset, but it remains challenged in terms of the pre-COVID level. So one that we continue to sort of monitor, but one where we've got a path to continue to work with the sponsor and help them really sort of manage through the situation. Got it.

And how would you describe the overall commercial real estate situation? lending markets from a stress perspective. I know there's a lot of concern. Could you just talk about it from a high level?

Sure, Dennis. Matt, I can jump in there. I guess a couple things. One, I think it's lagging the more liquid markets. And so it's certainly, we haven't seen anywhere near the level of yield compression that you see in the corporate credit market or the securitized markets. markets. There's clearly a lag in the private markets or specifically in CRE lending. There's a bifurcation, like I mentioned before, between the have and the have-nots, right? And that's really by property type for the most part. To some extent, business plan and the transitional lending segment, but predominantly property type. And so there's definitely a whole swath of retail assets and hotel assets that you just don't have access to financing today or it's extremely expensive. And then as it relates to the business plans, as you can imagine, the more transitional you get, the heavier the lift is, it's going to be tougher to finance right now. And again, that's a, you know, we're in an unprecedented market and I think people are cautious right now. And so you can understand the conservatism on the lending front with those assets. And then I would just say in terms of the participants in the market, what we're seeing, at least in our space, is there's definitely less competition, which is making it attractive and perhaps why we're lagging here. But there's capital out there. I wouldn't call the market distressed. We're lending at 4% to 4.5% coupons. I think that's attractive, but I don't think it's distressed. And you do see a number of participants in the market, as you would expect, The secure type lenders are back. We see a BS product both on large loans as well as on conduit. Insurance companies are very active. I would say one of the sectors where we haven't seen as much activity are the big money center banks. And so that's one area that we're watching closely. Thank you.

Thanks, Tom. Next question comes from Stephen Laws of Raymond James. Please go ahead.

Hi, good morning. I guess first I want to ask about the LTVs on the new originations. I noticed two were refinances, so you would have done a new valuation analysis in October. Can you talk about how much the value declined on those two, appraised value declined on those two assets from the loan they were refinancing, which I would assume that that valuation was done pre-COVID. And please let me know if that's not the case.

Yeah. Thanks for the question. I don't think I have the exact answer in terms of like the appraisals lined up from their pre-COVID to what we're doing today. I will tell you on the multifamily assets, on the lease up multifamily assets, we're generally underwriting down, call it 10 to 15% area in value, just because it's taking longer to lease up and there's clearly a concession package involved in today's market. So it's really the cash flows that are changing the valuation. As you would expect in this kind of interest rate market, we are seeing and we expect to see more cap rate compression once the assets have stabilized. But it's taking longer to get there in our underwriting.

Okay. And then shifting over to the change in core and then coupled with that an outlook on the dividend, you know, kind of – believe CECL is a non-cash item, the CECL reserves. So I would love kind of a little more background in your thoughts to now include that non-cash CECL change in the core metric, you know, especially with some of the inputs that go into that being macro and not company specific. Additionally, you know, I think historically we've used core earnings as a proxy for the dividend, but I don't believe that CECL is something that impacts re-taxable income, which determines the dividend distribution. So can you talk about going forward after this change, what we should look at as a proxy? Should we simply take your core earnings and back out CECL the way it's been done? And to that point, any spillover income from last year, any income you can spill forward, that we need to think about with regards to, you know, satisfying the 90% distribution requirement for this year.

Good morning, Stephen. Thanks for the question. This is Mustafa, so I'll take that one. So just to clarify, the change in the core earnings presentation prospectively is a result of an SEC comment that we received directing us to no longer exclude the provision of credit losses. for a portion of the provision for credit losses from our core earnings presentation going forward. And we intend, we noted that in our MD&A and also as noted by Michael in his prepared remarks. So we will implement that change starting with Q4 and all subsequent reporting periods. And obviously for consistency, we will recast our core earnings presentation for the first three quarters to correspond with the new presentation. That said, we don't believe that this is a change in the presentation of core earnings for reporting purposes. And obviously, the CISA provision will continue to be reported as a single line item on our income statements. So, you know, anybody can do the math there. With respect to the coverage from a dividend standpoint, I think the old, you know, presentation of core earnings would be a good proxy. And we believe that we will meet the distribution requirements from a dividend standpoint for this year.

Great. Appreciate the time today and the comments. Thank you. Thank you.

The next question comes from Charlie Orestia of JP Morgan. Please go ahead.

Hey, good morning, guys. Thanks for taking the questions. A bit of a follow-up on the CECL there. Look, I think there's There's no better demonstration of kind of a more, you know, incrementally positive economic outlook than putting money back to work. In that context, should we see some tweaking of that CECL reserve going forward? And just how are you guys thinking about the overall reserve rate on the portfolio?

Yes, this is Mustafa again. So I think a good question, would it stick to the reserve outlook? I think obviously the reserve will fluctuate quarter over quarter, depending on a variety of factors, including obviously our originations, volume, our repayments, velocity, and also changes to the macro on top of that. But generally speaking, everything else equal, we would expect, you know, the biggest driver for the change in the CESA reserve would be resolution of any of the of the watch list loans or the four and five rated loans and also the macro outlook over the next few quarters. So those will be the two key drivers.

Okay, got it. Thank you. And then just an unrelated follow up. I know there was some deferred interest discussions on I think the Portland loan, but I'm just wondering if there were any other additional loan modifications that were kind of executed during the quarter.

Hi, Charlie. Good morning. It's Patrick. So in terms of the quarter, we obviously had the two hotel loans where we had modifications in place. There was one other modification related to interest payments, which is on the New York condo loan, which I talked about earlier. And there we entered into a partial forbearance on a portion of the interest payments. There was a little bit of pay down associated with that. But that's it in terms of, you know, interest-related modifications in the quarter.

Great. Thanks so much for taking the questions, guys.

Thank you.

This concludes our question and answer session. I would like to turn the conference back over to Michael Shapiro for any closing remarks.

Thank you, everybody, for joining us today. We hope you stay safe, stay healthy, and if there's any follow-up questions, please feel free to reach out to any of us. Thank you again.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.