KKR Real Estate Finance Trust Inc. (KREF) Q3 2018 Earnings Report, Transcript and Summary

Good morning and welcome to KKR Real Estate Finance Trust Incorporated Third Quarter Financial Results Conference All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Sasha Hamilton. Please go ahead.

Thank you. Welcome to the KKR Real Estate Finance Trust Earnings Call for the third quarter 2018. I'm joined today by Christen Lee and Matt Salem, Co-CEO Patrick Mattson, our COO and Mostafa Nagaty, our CFO. Before we begin, I would like to remind everyone that we'll refer to their 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 forward-looking statements, which do not guarantee future events or performance. Please refer to our most recently filed 10-K for cautionary factors related to these statements. A quick recap of our results, before I turn things over to Chris. For the third quarter 2018, our GAAP net income was $20.8 million or $0.37 per share. Net core earnings were $21.4 million or $0.38 per share, up 18% from the prior quarter, excluding the gain on our sale of CMBS B-Piece investments in the second quarter. Book value per share as of September 30, 2018, was $1.15 billion or $19.76 per share. In October, we paid a dividend of $0.43 per share with respect to the third quarter. Based on yesterday's closing stock price of $19.89, the dividend reflects an annualized yield of 8.6%. Our board has scheduled to meet in mid-December to discuss the fourth quarter dividend, and we'll make an announcement shortly thereafter. With that, I would now like to turn the call over to Chris Lee.

Thank you, Sasha. Good morning and thank you for joining us for our third quarter earnings call. This was another very active quarter for the company. We originated $681 million of loans and closed an additional $122 million of senior loans post quarter end. This brings us to total year-to-date originations of $1.9 billion compared to $1.5 billion for the entire year 2017. We have secured a robust pipeline of another $621 million of loans currently under exclusivity that we expect to close in the coming months, subject to customary closing conditions. As of today, the total portfolio stands at $3.5 billion, a 62% increase since the beginning of the year and a 168% increase since the second quarter of 2017, when we completed our IPO. Matt will provide more details on our investment activity shortly. This quarter, we also increased our total financing capacity to $2.9 billion compared to $1.8 billion at year end, and we made progress on improving the cost and structure of our liabilities. We put in place a new $200 million non-mark-to-market facility and subsequent to quarter end, we increased the size of our term financing facility by $400 million to $1 billion. Patrick will provide the details in his remarks. Including this increase, nearly 40% of our financing capacity is now non-mark-to-market. Finally, this quarter we successfully completed our first follow on offering post IPO for 5 million primary shares in net proceeds of $98 million. Increase in our book value by 9% since the second quarter to $1.1 billion. This capital allowed us to continue to fund our robust pipeline. Assuming no near-term repayments with the aforementioned pipeline, we expect to be substantially deployed by the end of the quarter. The market environment continues to offer us attractive investment opportunities, but remains very competitive. However, our relationships with borrowers and intermediaries are growing brand awareness and our access to information to quickly assess credit continue to differentiate us in the marketplace. In addition, we have been able to reduce our cost of liabilities to offset some of the spread compression. Our attractive cost of capital has allowed us to compete effectively on price in the market and continue to deliver an attractive risk adjusted return-on-equity to our shareholders. Overall, we are pleased with our origination activity, our market positioning, our portfolio and pipeline. Despite some recent equity market volatility, we believe the economic climate remains favorable for our business model and we look forward to continuing to create value for our shareholders. With that, I'll turn the call over to Matt.

Thanks, Chris and good morning everyone. I'll start by discussing our investment activity. In the third quarter, we originated four floating rate senior loans, totaling $681 million. This includes the refinance of an existing loan in our portfolio, creating a new $75 million senior loan, secured by an 84% occupied. Class B plus industrial property located in Atlanta, Georgia, with an additional 18 months of call protection. The other three loans are collateralized by a Class A minus and B plus multi-family portfolio located in Atlanta and Tampa, a Class A multi-family property located in Seattle and two Class A office buildings also located in Seattle. The weighted average LTV and coupon for these four loans are 73% and LIBOR plus 3.2% respectively and on a levered basis, the loans have a weighted average underwritten IRR of 11.6% at spot LIBOR which is consistent with our existing portfolio. These loans fit our program of light, transitional lending to institutional sponsors in major markets. The average occupancy of these properties is 91% which creates in-place cash flow and the possibility for near-term stabilization. Year-to-date we originated $1.9 billion of senior loans, with a weighted average LTV and coupon of 70% LIBOR plus 3% respectively. This volume is 49% higher than the same period in 2017 and 31% higher than full year 2017 originations. Our average loan size is also increasing, with an average of 139 million year-to-date, up 17% from the same period last year. Also of note, our origination activity is driven by existing relationships as three of the four loans this quarter and 50% of the loans originated year-to-date are to repeat borrowers. Borrower experience is important in transitional lending. We pride ourselves on being responsive and providing high quality service. Our ability to convert existing borrowers to repeat borrowers speaks volumes about our team, process and reputation. Our strong origination pace has continued into the fourth quarter. We have already closed two senior loans, totaling $122 million. The loans are secured by a Class A multifamily properties, located in Queens and Philadelphia. Both loans are to repeat borrowers, and have a weighted average LTV and coupon of 72% and LIBOR plus 2.7% respectively. Our forward pipeline is robust as well with four loans totaling approximately $621 million under exclusivity to close over the next few months. Half of these loans are to repeat borrowers. As always, these are subject to customary closing conditions. In terms of repayments, we had $281 million of loan repayments in the quarter, resulting in $2.1 million of prepayment income. These repayments included two loans on retail properties, reducing our exposure to that property type to 4%. In addition, we had a $9 million pay down of our condo inventory loan this quarter, associated with the sale of units, and an additional $8 million pay down subsequent to quarter end. As our portfolio seasons, we are starting to see a pickup in repayment volume, and we expect to enter a run rate payoff schedule in the first half of 2019. Turning to our portfolio, as of September 30th, the portfolio was $3.4 billion, with another $386 million of future funding obligations, 100% of our loans are performing. And our securities portfolio is performing as expected. The portfolio is 98% invested in senior loans and has diversified both geographically and across property types, of this and multi-family loans comprise 87% of the portfolio. As we discussed in the last few calls, we continue to concentrate on the multifamily and office property types, due to their shorter term, light transitional business plans. As of quarter end, the average occupancy of the office properties in our portfolio was 77%. We are focused on creating a defensively positioned portfolio and we will continue to target the highest quality opportunities, trading incremental yield for credit quality. In summary, we are ahead of our target pace of originations with approximately $2.6 billion of loans closed or pending closing as of today. And we are pleased with the quality and performance of our portfolio. Now, I'll turn the call over to Patrick.

Thank you Matt and good morning everyone. Our portfolio, which totaled $3.4 billion at the end of the quarter, has a weighted average risk rating of 2.9 on a five point scale, consistent with the prior quarter. We have no loans with a rating above a three as our 1 4 rated loan paid off in the quarter. Additionally, as of quarter end, 98% of the portfolio was invested in live or based floating rate loans, which positions us well to benefit from further increases in short term interest rates. Looking at the right hand side the balance sheet, we continue to optimize our financing. As discussed on the last few calls, we have been working closely with KKR Capital Markets to explore funding options, and improve the cost and structure of our liabilities. This quarter, we closed on a new $200 million assets specific financing facility, which is match term, non-mark-to-market and partial recourse of the company, and funds at a rate of LIBOR plus the mid one hundreds. Additionally, post quarter end, we increased the size of our existing term loan financing facility from $600 million to $1 billion of total capacity. As a reminder, this facility provides us match term financing, on a non-mark-to-market and non-recourse basis. As of September 30th, the weighted average rate on the term loan facility was LIBOR Plus 1.4%. The attractive cost of these facilities allows us to compete for the highest quality lending opportunities and secure better credits for KREF while still delivering an attractive return to the company. In addition, the liability structure is more durable from a mark-to-market perspective and improves our ability to manage risk and liquidity on the balance sheet. In addition to these new facilities, we also upsized our Wells Fargo repurchase facility from $750 million to $1 billion this quarter, bringing our total, committed financing capacity to $3.3 billion as of today. Turning to the debt-to-equity ratio. We closed the quarter at 1.3 three times and 1.9 times from a total leverage perspective. We continue to re-leverage the portfolio as we fund new originations and as a reminder, we generally target a three to four times leverage ratio on new senior loans. One other note on the balance sheet, this quarter, we issued five million shares of common stock through an underwritten offering in August, raising approximately $98 million of net proceeds. Wrapping things up, another strong quarter and solid start to the fourth quarter. Our origination pace remains robust. Our portfolio is performing and we continue to make significant progress, creating differentiated financing. Thank you again for joining us. And now, we are happy to take your questions.

Thank you. [Operator Instructions] The first question comes from Jade Rahmani with KBW. Please go ahead.

Good morning, this is actually Ryan on for Jade. Just in terms of the $621 million pipeline you mentioned, can you give us some detail on the types of loans you -- that those represent you mentioned. I think four loans, so maybe, the average spread on those deals and the types of properties in markets.

Hey Ryan, It's Matt. We're still in the process of closing those. I don't think we want to go into specifics on the spreads yet, but I would say that it's largely in line with what we've delivered over the last few quarters in terms of both, business plan focusing on light transitional properties as well as you know as well as the coupons that we're originating at. We haven't seen a lot of changes in the -- in this spread complex over the last quarter or two.

And then as a follow up to spreads, do you think that the spreads have generally troughed from the strong compression that we've seen year-to-date. Or do you think that there is additional room for spreads to continue to compress assuming the fed continues on its expected path of rate hikes?

I think, as I mentioned before, it does feel like there's been some stability in the spreads over the last or the last few quarters. But as we’ve seen, you do see compression as we’ve seen increases in LIBOR. Our expectation is that would continue as rates go up.

And given the large average loan size that you mentioned, I think like a $140 million year-to-date, which was up around 17%. Can you talk about how you think about concentration risk in the portfolio and maybe more generally your approach to asset management across the portfolio.

Hey, this is Chris. From a concentration perspective, we take a -- we look at these deals on a, really, on an individual basis. For instance, the large loan that we made in this past quarter, it's actually a loan that if you broke it up into the loan in Atlanta or the loan in Tampa, you would actually look at those as not being that large from a concentration perspective. We actually think we're getting better risk-reward by the fact that those loans are actually cross. So we actually think about that as a derisking because those loans are cross not that it actually made our exposure larger. I guess from a geographic perspective, we always monitor how much exposure we have to any particular geography. Right now, we don't think we have any outsized concentration, including property type. We focus on as well, and we, as Matt mentioned in the remarks, we like the multifamily and lighter transitional office sides. So we do make -- we do take some concentration areas where we think that we like the fundamentals and we like the risk profile. From an asset management perspective, we clearly meet quarterly, we go through all the risk weightings, we go through all the business plans. Our team focuses on all these loans on a -- really a monthly basis. So we've very up to speed on the progress of these business plans. And right now, we're very happy with the quality of the portfolio and the underlying performance of the collateral that we have went on.

And just lastly, not sure if you are able to comment, but we’ve seen the pre-sell reports in the market for a CLO from you guys, just wondering if you are able to give us any color on that? Maybe just the rationale behind the attractiveness of doing a CLO?

Good morning, Ryan, it’s Patrick. As we mentioned on some previous calls, we’re actively looking to diversify our financing sources and increase kind of are non mark-to-market capacity. But can’t comment on any potential transaction. But we’ll certainly update you on any material developments when we’re in a position to do so.

Okay. Thanks for taking the questions.

The next question comes from Don Fandetti with Wells Fargo. Please go ahead.

Good morning. So on the 341 million multifamily in Southeast this quarter, can talk a little bit about how you won that deal? Were there other bidders? And then, I think I could be wrong, but it sounds like maybe that was a little bit more of a leaning towards a stabilized property and we hear about banks highlighting that non-banks are taking share. Is this the type of loan that would have potentially met the criteria of a bank? And can you talk about that theme in general what you think of that if it's good or bad because on one hand maybe the non-banks are taking credit that the banks don't want?

Hi, Don. It’s Matt. I’ll take that one. Just in terms of the sourcing, and I think you heard in our comments we’re driving a lot of our volume through existing relationships. And this is one example of that. So this is a repeat borrower for us. In terms of sourcing, they came directly to us. So there was -- we weren't in competition on this loan with either banks or other debt funds or mortgage REIT. So its just a direct negotiation on this particular deal. I think it highlights where we like to focus in terms of the light transitional nature of the business plan. But it still going through some value add and so that’s keeps the banks away and I think sponsors didn't want or probably couldn’t access some of the bank capital given that there's still some value add going on the asset. They’ve largely renovated the asset, so they’re 80% to 90% through a renovation plan. However, I don't think they’ve realize the full renovations. They’re still delivering some of the amenities. So there's still -- they still – our sponsors still expect increases in rents over the next year or so as all those packages come online. And then secondly, part of our collateral, small component of the collateral was recently delivered, was recently constructed and is in the process of lease-up. So its around 50% lease today that obviously has a certificate about inventory has been built and is in the process being leased. And so, the business plan for our sponsors just to stabilize the property occupancy perspective as that lease is up. Properties been around 90% leased today and so it’s probably got a few more points of leasing to go especially on the newer constructed component of it. And then obviously continue to drive rents higher as the renovations and the amenity packages are put in place. So this is a perfect example of our ability to lend on an asset that still going through some value add, but is close to stabilization. To a repeat sponsor, we’ve got a great relationship on a non-competitive basis.

Okay. And then, I guess maybe a follow-up, rates continue to go up on a short and on the long end a little bit. Have you seen any changing behavior in terms of borrowers. It seems like the deal flow across the commercial mortgage REIT space continues to be fairly healthy. And do you expect – are you worried about the velocity or transactions slowing down? What are you seeing today from higher rates?

I mean, up to this point we haven't really seen any impact. And I think most of our borrowers are traditionally floating rate borrowers that are implementing some type of value-add strategies. So – and if you look at our origination volumes over the last few quarters and look at the pipeline for the fourth quarter these are been most active origination course we've had. So don’t – we aren’t seeing any impact to that, and I don’t think we’re particularly worried about it.

Thank you.

The next question comes from Steve Delaney with JMP Securities. Please go ahead.

Good morning and congratulations on the earnings beat this quarter. I would like to ask you little bit about repayments, $281 million in the third quarter. Can you give us a feel for how the fourth quarter might look relative to the third quarter? And then looking out to next year if we were to assume something like a 30%, 35% annual runoff rate over next year. Would that seem realistic to you? Thank you.

Hey, Steve, it’s Chris. Thanks for the complement. With respect to your question we – remember, our loans are quite sizable, so we do have some lumpiness in the repayments. So it's hard to project out. But we do -- I think that by next year, at least in the first half of next year we’ll get on a more normalized repayment schedule. So I think your 35% of the book feels probably about right once you get into that that normalized basis. Remember, most of our loans are 2017/2018 vintage loans as the book is still a little bit less season than some of our competitors in the market. But that that assumption feels like a pretty good runway once we get on a more normalized on the light path.

Okay. That’s helpful. Thank you, Chris. And then just looking at the portfolio today 3.8 billion, Patrick went through some of the new financing facilities that you have. How much additional net lending capacity do you see that you have at this time or if you’d rather get out this way in terms of this core loan portfolio, how large could that grow to with your current capital base? Thanks.

Steve, its Chris again. So -- we think that after this pipeline closes that we discussed at the beginning of the call, we think we’ll be substantially deployed with existing capital base. So in the short term we want to get these loans on the books in the next quarter and then have that -- have the portfolio in the earnings profile of the company season. But we think that given the size of our team and given the size the opportunity set that we have the ability to originate similar types of loan volumes over that we've experienced over the last – over the last couple of quarters. So, we’d expected some point we’ll need to continue to grow our equity base and our database to continue to support the origination volume and the demand for our product that we’re seeing from our clients and borrowers.

Chris, that pipeline that you referred to is that is that the 620 million that that Ryan mentioned in his comment?

Yes. That’s we mentioned.

Okay. Thank you very much for the color.

[Operator Instructions] The next question comes from Rick Shane with JPMorgan. Please go ahead.

Hey, guys. Thanks for taking my questions. I just want to follow-up a little bit on what Steve was discussing in terms of repayment. During the quarter you guys had $281 million, you cited $72.1 million in fees associated with that, that equates to about 75 basis points on repayments. As you move into 2019 should we assume somewhere in the 50 to 75 basis point range for repayment fees?

Rick, good morning, it’s Patrick. The prepayment fees are difficult to model. There obviously we get repayment fees if those borrowers repay during this spread maintenance period. As this loan season and as they hit their business plan they hit an open period and obviously we don't collect prepayments. So we don't -- as we forecast we don't sort of model any sort of prepayment income. That said, it's not uncommon for us to receive it. We’ve received it in past quarters. I would expect that we would receive it in the future. It just difficult to model.

Sure. Yes. It certainly a recurring part of the business. So is one way to think of this that and alluded the fact that as you go into sort of a more, more normal repayment cycles opposed to a early repayment cycle battle drift down. Is it also fair to assume that only payments may slow a bit as spread tightening starts to abate the incentive to repay early start to go away?

Yes. I think it’s a fair statement.

Okay. Last question, which is just geography. I want to make sure that we understand exactly where the 2.1 million went through the P&L. There's 476,000 of other income, I’m assuming the bulk of that income went through the interest income line. Can you just help us, map it out?

Good morning, Rick. This is Mostafa Nagaty. Hope you’re doing well? $2.1 million of prepayment penalties income is actually reflected as interest income and the $52 million interest income during the quarter.

Okay. 100% of that goes to through the interest income line?

That’s correct.

Great. Thank you, guys for taking my questions.

Thank you.

The next question comes from Arren Cyganovich with Citi. Please go ahead. Mr. Cyganovich, your line is open. Perhaps its muted on your side.

Sorry about that. The geography exposure, maybe you just talk about where you’re seeing maybe extra supply. I know you have more of a lean towards multifamily and office. Maybe you can just talk kind of broadly about the supply for those asset classes and if there’s any particular areas where you feel better or worse about financing?

Arren, it Chris Lee. I think on supply it’s very specific to the markets. But maybe we clearly focus on the lot in the multifamily space. We are very cognizant of certain markets, in some of the Sunbelt markets where there is supply. That being said, we are very focused on our basis. Atlanta for instance, has supply in the multifamily side. But our particular deal that we just made a loan on that Matt went through is anymore infill part of Atlanta, its right off of 285 in the loop from our perspective and its much more supply constraints. So we look at a lot of these markets on in more micro basis. But in the multifamily space we focus on a lot. On the office side we are focused on not just supply of new buildings but also rehabilitation and adaptive reusable building because lot of our buildings end up being renovated to a new spec and we’re focused on how many other similar business plans are going on in the market and then factoring in that supply relative to the net absorption that we’re seeing and then coming to our own view on whether that supply demand makes sense to lend on. And I think the last part is, in addition to supply we focus on the basis that are borrower owns the property at, because you might have supply in the market but if you're borrower has a basis where they are effectively meeting or even undercutting rents and this could office, it could be multifamily, it could be other property types, that dynamic is also important. And I think the last part is, we mitigate a lot of this through loan structure and making sure that we have milestones within our loans that allow us to track these business plans and if we aren’t seeing the improvement in the property that we've underwritten then we have the ability to turn off future funding or enter cash sweep et cetera to make sure that our loan is deleveraging if the business plan is not going as planned. So long answer but it’s a nuanced question. Its not just we look on our map and see how many buildings are going out. Its much more of a micro focus.

Very helpful. Thank you.

This concludes our question and answer session. I’d like to turn the conference back over to Sasha Hamilton for any closing remarks.

Thank you everyone for joining us today. If you have any further questions, please call me after the call. Thank you.

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