KKR Real Estate Finance Trust Inc. annual report, FY2017

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KKR Real Estate Finance Trust Inc. — 2017 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2017. KREF is an externally managed mortgage REIT focused primarily on commercial real estate senior loans, with additional mezzanine loans, preferred equity and CMBS B-Pieces. Its shares began trading on the NYSE in May 2017. The company completed its IPO, raising $225.9 million net.

Financial and portfolio highlights

  • Earnings: Interest income was $83.1 million, interest expense $21.2 million and net interest income $61.9 million, versus $32.7 million, $7.4 million and $25.2 million, respectively, in 2016. Other income was $17.7 million, including $15.8 million from consolidated variable-interest entities (VIEs). Net income attributable to common stockholders rose 89% to $58.8 million; diluted EPS declined to $1.30 from $1.61 as the weighted-average share count increased to 45.3 million from 19.3 million.
  • Supplemental earnings: Non-GAAP Net Core Earnings were $55.5 million, or $1.22 per diluted share, compared with $27.8 million, or $1.44 per diluted share, in 2016. The company cautions that its Core Earnings measures are not GAAP and may not be comparable with other REITs.
  • Fourth quarter: Net interest income was $19.8 million and net income attributable to common stockholders was $17.0 million, or $0.32 per diluted share. The declared quarterly dividend was $0.37 per share.
  • Portfolio: The reported portfolio value was $2.083 billion, up 148% from 2016; it was described as 100% performing, 93% floating-rate, with a 67% weighted-average LTV. Senior and mezzanine loan exposure included $1.965 billion principal and $316.2 million of unfunded commitments. The filing reports no impaired investments, past-due loans or loans on nonaccrual at year-end.
  • Equity and dividends: Year-end stockholders’ equity was $1.059 billion and book value per share was $19.73, down from $20.60. Dividends declared totaled $1.62 per share for 2017 versus $1.22 in 2016.
  • Debt and liquidity: Secured financing agreements were $964.8 million net of issuance costs; loan participations sold added $81.5 million of liabilities. Total leverage ratio was 1.0x versus 0.7x in 2016. Cash and cash equivalents were $103.1 million, with $140.6 million of available facility borrowings and $4.6 million of principal payments receivable. The company was in compliance with financing covenants.
  • Cash flow: Operating cash flow was $53.8 million, investing cash flow was negative $1.084 billion, and financing cash flow was positive $1.037 billion. Year-end cash, cash equivalents and restricted cash totaled $103.5 million.

The consolidated balance sheet reports total assets of $7.395 billion, including $5.373 billion of VIE mortgage assets and $5.257 billion of corresponding VIE liabilities. These trust liabilities are non-recourse to KREF; the grossed-up VIE balances should not be interpreted as ordinary corporate debt. The filing does not present a conventional operating-margin measure.

Material changes versus 2016

  • KREF expanded substantially: year-end portfolio value increased 148%, book value increased 113%, and committed new floating-rate senior loans reached $1.483 billion. Net interest income rose $36.7 million, primarily due to the larger invested portfolio.
  • Management fees increased to $13.5 million from $5.9 million, while general and administrative expenses increased to $4.9 million from $2.3 million, reflecting greater equity, growth and public-company costs. No incentive compensation was recorded in 2017, versus $0.4 million in 2016.
  • Net income grew, but per-share earnings and book value per share fell amid significant equity issuance and a larger share base. The company issued 11.8 million IPO shares and also completed pre-IPO equity issuances.
  • Borrowing capacity increased to approximately $1.8 billion from $1.5 billion. The company added a $75 million Barclays revolving facility and amended or expanded several repurchase facilities.

Outlook, risks and unusual items

  • Management expects future originations to emphasize floating-rate senior loans financed through repurchase facilities; it expects the portfolio share of CMBS B-Pieces to decline over time. The stated target for senior-loan leverage is 3-to-1 debt to equity, compared with overall leverage of 1-to-1 at year-end. These are strategic expectations, not earnings guidance; no quantified earnings or dividend guidance is provided.
  • Management states that rising rates generally could increase earnings because most investments and financed assets are floating-rate, while noting that funding costs also rise and fixed-rate assets may lose value. A 50-basis-point short-rate increase was estimated to increase cash flows by about $2.8 million based on year-end exposures.
  • Key risks include borrower/property credit deterioration, collateral and fair-value uncertainty, leverage and repurchase-facility margin calls, refinancing and financing availability, interest-rate and LIBOR transition risk, illiquid or subordinated investments, and concentration or competition. The filing also highlights REIT and Investment Company Act qualification risks.
  • KKR controls the company and manages it under a fee arrangement; KKR’s special voting share gives it majority voting power in director elections while specified ownership conditions remain. The filing describes potential conflicts in allocating opportunities and resources among KREF and KKR-affiliated vehicles. The management agreement also includes a potentially material termination fee.
  • Year-end commitments included $316.2 million for loan funding and $26.0 million remaining for the RECOP aggregator investment. Subsequent to year-end, KREF originated a $70 million-funded floating-rate loan, funded $19.1 million of prior commitments, received $33.3 million of mezzanine-loan repayments, paid the $0.37 quarterly dividend and repurchased 496,809 shares for $9.7 million.
  • Deloitte issued an unqualified audit opinion. Management considered disclosure controls effective; the annual report did not include management’s assessment or auditor attestation on internal control over financial reporting due to the new-public-company transition.

Important facts for investors to verify

  • Reconcile reported portfolio value, balance-sheet loan carrying values and the distinct treatment of consolidated VIE assets and non-recourse liabilities.
  • Assess the quality and concentration of loan collateral, including the 67% weighted-average LTV, risk ratings and $316.2 million of unfunded commitments.
  • Review repurchase-facility terms, actual borrowing availability, collateral haircuts, margin-call provisions and maturities against loan assets.
  • Evaluate per-share earnings and book-value trends alongside equity issuance, dividends, share repurchases and manager fees.
  • Review KKR control, related-party arrangements, investment-allocation conflicts, and the management agreement’s renewal and termination terms.
  • Monitor the ability to maintain REIT and Investment Company Act status, and any effects of LIBOR replacement, tax-law changes or fair-value assumptions.