Musa 81
Austin Rogers Co-Producer
About a year ago, we conducted an extensive analysis of commercial mortgage REITs to see if we could find attractive value.
Residential mREITs' spread-based business models are less attractive to us and have led to lower long-term returns, while commercial real estate mREITs have performed better to varying degrees.
On a total return basis, only one commercial mREIT underperformed the VanEck Mortgage REIT Income ETF (MORT), which is heavily weighted towards residential mREITs.
The only struggling commercial mREIT, KKR Real Estate Finance Trust (NYSE:KREF), is only just starting to see its performance weaken just a few months after announcing a dividend cut.
Due to the possibility of this happening, we avoided investing in mREIT common stocks altogether last year. We only invested in two high-yield mREIT preferred stocks (ABR.PR.F, KREF.PR.A), both of which have performed well so far.
We have been steadfast in avoiding office real estate since COVID-19 due to our bearish view on the sector, and we believe this avoidance is justified. This also applies to mREITs. When we looked a year ago, all but the multifamily lenders (NexPoint Real Estate Finance (NREF) and Arbor Realty (ABR)) had between 18% and 34% of their total exposure to office.
Interestingly, nearly every mREIT we tracked last year has increased in price since then, with the exception of KREF.
It is therefore not surprising that all stocks except KREF are trading at higher levels relative to their respective book values compared to a year ago.
If you believe book value (and book value measures are generally much more accurate for mREITs than for equity REITs due to the lack of depreciation), KREF common stock can be purchased for essentially 50 cents on the dollar today.
Anytime an mREIT trades at such a large discount to its book value, it means the market sees losses coming, and in KREF's case, this discount means more losses are coming, and in the worst case scenario, losses could be enough to force the mREIT into bankruptcy.
However, it is possible that market pessimism about KREF is excessive, with the dividend cut causing the stock price to fall unfairly.
Seeking Alpha contributor Trapping Value has suggested avoiding or selling KREF, and that further dividend cuts are likely. TV also certainly makes the correct point that KREF is heavily indebted. Its balance sheet assets total about $7.5 billion, excluding credit loss reserves, and total liabilities are about $5.8 billion. Thus, a loss of $1.7 billion (23%) or more on the loan portfolio would wipe out all of KREF's shareholder equity.
The risks are high for KREF right now, but so are the potential rewards.
Also consider the fact that two of KREF's executives (the CEO and COO) purchased a combined $350,000 worth of KREF common stock in the months prior, shortly after the dividend cut was announced, and the price they paid ($9.72 per share) is roughly the same as what the stock is still trading at today.
Let’s look at some other ways in which KREF benefits.
Explore KREF
KREF is an mREIT focused primarily on multifamily and industrial real estate, with 58% of its loans secured by real estate in these two sectors. All of its loans are senior in the capital structure and 99% are floating rate.
Office represents 22% of loan balances and is currently the most troubled sector, but the good news is that 93% of office properties are Class A, so any operational downside or potential losses should be minimal.
Its parent company, KKR & Co. (KKR), one of the leading alternative asset managers, gives KREF access to its vast network and resources to originate and manage loan portfolios. KKR owns 14% of KREF.
The company's weighted average loan-to-value ratio is 65% as of the first quarter of 2024. While currently higher than desirable, this metric suggests that the market value of its underlying properties would need to fall by more than 35% for KREF to incur permanent losses.
It could happen. As can be seen in the top left graph of the image above, more than a third of the company's loans were made between Q4 2020 and Q4 2022, a period of low interest rates and rising property prices. It's quite possible that some of the properties covered by KREF's loans made in 2021 and 2022 have lost more than 35% of their previous market value.
However, as discussed below, KREF's management has expressed confidence that it will be able to sell its real estate holdings and reinvest the proceeds to recoup some of its lost distributable profits, suggesting that KREF's ultimate losses will not be significant.
Last year, KREF played defensive games, lending out less new loans than it was paying down.
This has resulted in a gradual reduction in total loan balances without a significant decline in operating cash flows.
KREF has about $183 million worth of real estate it owns that it is preparing to sell. Typically, this would simply involve leasing buildings to make them more attractive to investors, but owning real estate comes with operating costs.
The book value of $15.18 per share will only be truly credible if KREF eliminates any further losses on its loan book and if the real estate holdings actually sell for around $183 million.
However, it should be noted that KREF's watch list includes four properties with the highest risk ratings below outright default, totaling $700 million (3.8 times the value of KREF's real estate holdings).
Additionally, KREF has four properties with $395 million in principal balance with the next lowest risk rating of 4. These are stressed properties and it is unclear whether they will recover from here.
As discussed below, management does not expect any further risk shifts to occur in the portfolio in the near future.
The four risk level 5 properties currently owned by KREF following foreclosure are not necessarily properties you would want to own in today's market.
Office and life sciences are currently suffering from oversupply, and West Coast states are lacking the levels of population and job growth enjoyed by other parts of the country.
However, management remains confident in its ability to reposition and sell these properties in a timely manner.
KREF's balance sheet is a positive aspect of the company: while debt is high at a debt-to-equity ratio of 2.1x, there are no corporate-level debt maturities until 2026 and few asset-backed maturities in the interim.
This will minimise pressure on KREF from interest expenses.
However, since KREF's portfolio is essentially all floating rate loans, debt maturities aren't the main threat the mREIT has to worry about at this time.
Comments on the First Quarter Conference Call
Here are some highlights from our Q1 2024 conference call:
KREF's largest real estate sector, multifamily (overwhelmingly Class A), has been performing well.
Multifamily properties make up 43% of the company's portfolio and performed well, with weighted average rents increasing 3.4% year over year.
First, KREF has been largely inactive on the investment side over the past year or so as it has been dealing with credit issues, but management expects activity to return in the coming quarters.
With U.S. banks still largely on the sidelines and market activity picking up, we expect this supply-demand imbalance to normalize and potentially reverse, creating an attractive opportunity for KREF to fill the void as lending resumes in the coming quarters.
Although fundamentals for office real estate remain poor and are not expected to improve anytime soon, KREF does not believe it will experience any further defaults or problems with its office loans.
KREF continues to feel that it has identified potential office issues within its portfolio that are on the watchlist and does not expect any further negative rating transfers from the office sector to the watchlist.
Management has expressed confidence that the newly instituted dividend is sustainable, with a yield above 10%.
As discussed last quarter, we have targeted our dividend to be covered by distributable earnings, excluding losses in our performing loan portfolio, under a variety of scenarios, and we expect that in the near term, distributable earnings, excluding losses, will continue to significantly exceed our dividend.
KREF does not have liquidity issues.
With the backing of KKR Capital Markets, KREF had $620 million in liquidity at the end of the quarter, including $107 million in cash on hand and $450 million of unused corporate revolving loan facilities.
KREF may sell and reinvest its real estate holdings, which could increase its distributable income.
As we stated last quarter, we continue to carefully optimize our REO portfolio, and as we sell these assets, we believe we will be able to reinvest capital to generate additional distributable earnings of $0.12 per share per quarter.
For all these reasons, we are considering opening a position in KREF common stock today. We believe that KREF faces much smaller losses going forward than its large discount to book value would suggest. If we are correct, there is potential for 50-100% upside over the next few years, plus a very high dividend yield while we wait. We will await second quarter results before making an investment decision.