Description

KREF – Thesis

All figures presented in US$ millions, except for per share data. Share price data as of 7/1/23.

KKR Real Estate Finance Trust Inc. (“KREF” or the “Company”) is a commercial mortgage REIT.  The Company makes investments in senior secured loans for transitional commercial real estate projects.

At current pricing, the 1L yields ~9.6% or a ~450bps spread over SOFR.  We believe the KREF 1L presents an attractive risk/reward relative to the credit risk assumed.  Even assuming highly punitive stress scenarios, we calculate a full recovery to the 1L.  

Transitional properties generally operate below their cash flow potential as a result of low occupancy and rents, underinvestment, or underutilization.  The property owner seeks capital to execute a lease-up strategy, revitalize the space, or reposition the asset.  Loans are typically structured as short-term floating rate capital for a 2-3 year term, and with future funding provisions that provide additional advances upon the achievement of performance thresholds.  Upon stabilization, the borrower typically seeks to replace the transitional loan with fixed long-term debt to reduce its cost of carry.

KREF’s loan exposure includes: 1) Multifamily loans equal to 44% of assets, underwritten at a weighted average (“WA”) LTV of 69% and loan per unit of ~$357k.  The vast majority of these loans are for newly constructed properties where the capital is a bridge between a construction loan and a stabilized lender during the lease-up period.  2) Office loans are 25% of assets, underwritten at a WA LTV of 64% and loan per square foot of $409.  The Class A mix of office loans is 95%.  Office loans are primarily for ~70% occupancy assets going to 80-85% post renovations (light renovations, such as the addition of a gym).  3) Industrial loans are 13% of assets, underwritten at a WA LTV of 59%.  4) Life Sciences loans are 8% of assets, underwritten at a WA LTV of 64%. 

The Company’s equity and debt securities have traded off alongside the commercial real estate (“CRE”) space broadly.  The equity trades at a -30% discount to book value and a ~14% dividend yield.  The principal investor concerns are (i) KREF’s book value will be revised down as credit losses materialize above the Company’s credit loss allowance; (ii) the sustainability of the dividend given potential for lower interest income following loans that default; (iii) capital availability given recent regional bank challenges.

Though experienced credit losses moving forward will almost certainly be higher than the Company’s credit allowances, thus warranting a discount to book value for the equity, we believe KREF’s corporate debt is well covered.  The 1L is supported by ~$1.9bn of equity cushion (book value of common equity plus preferreds) vs. a $7.9bn loan book.

Our thesis is: (i) the 1L can withstand material credit losses before impairment; (ii) limited near-term maturities and modest office exposure mitigate credit risk; (iii) liquidity is supported by undrawn warehouse lines and access to capital markets; (iv) underwriting new loans at current spreads is highly accretive.  

Ability to withstand credit losses

If all loans were to mature today, KREF’s loan book is able to withstand substantial credit losses before impairment to the 1L.  On a weighted average basis, KREF’s loan book can experience a -48% reduction in underlying property values – across all verticals, including multifamily / office / industrial / life sciences loans – before the 1L is subject to any impairment.

To calculate the credit losses KREF can endure before affecting the 1L recovery, we reviewed each individual loan and ascribed a reduction in asset value to calculate credit losses in a stress case scenario.  The Company discloses granular loan-level detail, thus enabling an investor to calculate recoveries based on: (i) LTV; (ii) loan per unit/SF; (iii) location; (iv) origination date; and (v) maturity.

The exhibit below summarizes our analysis – notably, we have assumed that the Office portfolio’s underlying asset values decline -70% and mature immediately.  We have also assumed underlying asset value declines of -42% for Multifamily, and -33% for Industrial and Life Sciences, respectively.

With these assumptions, which we view as a draconian stress case, there is zero equity value remaining and the debt securities are fully recovered.

Limited near-term maturities and modest office exposure

Office exposure represents 25% of the total loan book.  The WA LTV of Office loans is 64%, with 95% mix of Class A properties, and WA loan per square foot of $409.

Office loans maturing in < 1 year equal 2.5% of the loan book, and total Office loans maturing in < 3 years represent less than 15% of the loan book. Across all loans, only 29% mature in less than 3 years. 

Concerns relating to elevated defaults in Office are mitigated by low exposure to Office and even lower exposure to near-term maturities in Office.

Numerous liquidity options

KREF has sufficient liquidity through existing credit facilities to fund future funding obligations and underwrite new loans.  There are no debt maturities until Oct 2025 (the GS repo facility).  The revolver / 1L are not due until 2027, and the junior preferred security is a perpetual one.

KREF is able to fund future funding obligations through capacity within existing credit facilities at highly favorable terms: its weighted average financing cost is S+200 on committed facilities.  KREF’s $2.7bn of borrowing capacity through existing credit facilities compares to $1.4bn of future funding obligations (all of which may not come due, given future funding obligations are tied to specific performance milestones and often require additional sponsor capital).

We believe KREF would have no problem accessing the capital markets today for a term loan or CLO issuance, if needed.  At the moment, credit markets remain open albeit at wider spreads.

An outstanding concern has been the viability of the business model if KREF’s liabilities were repriced at wider spreads.  The concern is that if KREF has historically underwritten loans at ~300-400bps spreads, but today its own senior credit securities are priced at a discount margin of 450bps; therefore, the model would appear dilutive.  While this risk is mitigated by capacity on existing credit facilities (priced at S+200), it’s worth noting that a dividend cut or uneconomic terms for some liabilities would be dilutive only to equity holders and would not affect recoveries to the Company’s debt securities.

Favorable environment to underwrite new loans

Though the Company may opt to preserve liquidity during this period of uncertainty for the CRE space out of prudency, STWD on its Q1 2023 call suggested that transitional CRE loans are being underwritten at spreads as wide as S+900. 

KREF’s business model effectively captures spread in exchange for taking on credit risk.  While historically the model has borrowed at S+200 and lent out at S+340, the current market environment lends itself to highly attractive economics given wider spreads.  KREF is also structurally well-positioned to take advantage of wider spreads, given its $2.7bn of debt capacity priced at S+200. 

Risks

Warehouse facilities get pulled or marked-to-market

Though it’s rare to do so, banks providing KREF’s warehouse facilities may choose to no longer extend KREF capital for mortgage loans post-maturity.  The lending facilities have availability capacity, but the values must be agreed to by the lenders.  KREF’s repo facilities ($1.5bn drawn) are also subject to mark-to-market provisions, which the banks may choose to exercise and would further pressure KREF’s liquidity. 

Future funding commitments

KREF has $1.4bn of future funding commitments, $637mm of which are due in one year.  Over 50% of future funding obligations are earmarked for Industrial and Life Sciences loans (~2.5x their loan mix), due to their higher mix of construction projects.  Given $110mm of cash on hand, liquidity may be stressed if obligations materialize (tied to project milestones); particularly if obligations are due to performing Industrial / Life Sciences loans, while restructurings emerge in Office / Multifamily. 

Existing credit facilities can be used to fund these future obligations, but certain credit facilities require sign off from the lender relating to value and terms, and may be disputed given the recent stresses in the CRE market. Even with sign-off from lenders, the future funding obligations are tied to loans already underwritten, and thus the spreads on the loans are less attractive than new loans KREF could be underwriting. 

Catalyst

Near-term maturities materialize