imaginima/iStock via Getty Images
In our previous coverage of KKR Real Estate Finance Trust Inc. (NYSE:KREF), we identified possible reasons why you might not want to chase the stock: the share price has fallen and the big yield has failed to lift the total return into positive territory, with the total return trailing the broader S&P 500 (SPY) by nearly 27%.
We take a look at the recently released Q1 2024 results and explain why you shouldn't look away, even if things look good on the surface.
Q1 2024
KREF cut its Q1 2024 dividend from 43 cents to 25 cents. This was announced in February 2024. The quick lesson for investors is that this was entirely predictable from the GAAP earnings picture, but may have been missed from the distributable earnings metric. This is something to keep in mind, as investors tend to gravitate towards the metrics that give them the most comfort. The metrics that lead them to believe their earnings-seeking methods are still working are the very metrics they worship. So let's take a more objective look at Q1 2024.
At first glance, the dividend was nicely covered, with 39 cents of cash flow supporting the 25 cent payment.
Of course, you missed the 13 cent loss above the line because we distracted you with less important things. Look at the consolidated income statement and you'll see the real problem. The loss reserve was much larger. REITs, like Ares Commercial Real Estate Corporation (ACRE), are experiencing rising expenses on their owned properties.
None of these are good signs, and you shouldn't ignore the decline in tangible book value just because the REIT is trading even lower than that figure.
Overall, the quarter was largely in line with the trends seen in Q1 2023 through Q4 2023. Issues are slowly unfolding as REITs figure out the structural issues facing their core businesses.
Outlook
KREF expanded rapidly during the worst period in the commercial real estate market because these loans were made at a time when investors believed interest rates would be forever low.
Of course, this isn’t all office-related exposure: only 22% is purely office and 10% is life sciences, which may be related in some way (depending on compatibility with actual office space).
But we're also seeing Class B multifamily problems pop up all over the place, and defaults seem to be accelerating. All of this would be manageable if they were only funded with equity. But REITs are not. Their $7.3 billion in assets are backed by about $1.4 billion in equity. So results go up with leverage and they go down with leverage.
If things go wrong, it will be a double whammy as the REITs eventually bring their debt-to-EBITDA, or debt-to-asset ratio, back to normal. Banks and lenders do this to limit their risk and losses in this experiment. KREF's equity-to-asset ratio is quite high, much higher than the numbers ACRE released a few days ago. So don't get too comfortable here, even though the risk to office is relatively low.
Another way to do this exercise is to see what the KREF indicates as a problem loan: If you look at the KREF scale of 1-5, things don’t look so bad, right?
No. Loan allocation is important, but what is more important is the relative amount of non-performing loans to total capital. Here we highlight the carrying value of Level 4 and Level 5 loans and total loan exposure.
The book value of $935 million (after markdown) is currently at level 4 or 5. Here is the total capital again.
Are you still chasing income? If so, take a long look back at the tragedy of New York Community Bancorp (NYCB). Look at how little the company's exposure was relative to its total capital when it disclosed bad loans. Notice how that nearly triggered a bank run, forcing banks to issue stock well below tangible book value. The risk was there, and potentially still is. Certainly, KREF has limited its mark-to-market exposure to its debt.
Their overall leverage is also lower than that of banks, but their distressed-to-capital ratios are much higher.
verdict
Sometimes it's best not to buy when there's blood on the streets. Sure, you could jump in and buy something like this at 88% off.
But buying a property 5:1 leveraged when there is blood in the streets is not what you want. The odds are not in your favor. When this truly unravels will depend on credit spreads. Right now, things are optimistic and even ignore the possibility of further rate hikes. At some point, that white line will explode up and catch up to the level it needs to be.
If that happens, you'll regret owning KREF, which earns an “extreme” risk level (50%-75%) of another distribution cut on our proprietary Kenny Loggins scale.
I consider this a sale.
Please note that this is not financial advice. It may seem that way, but surprisingly it is not. Investors are urged to do their own due diligence and consult with professionals who understand their objectives and constraints.