Introduction
KKR Real Estate Finance Trust (NYSE:KREF) specializes in originating and investing in transitional senior loans backed by real estate. While I have not been interested in the common shares of the REIT, I have been monitoring its preferred shares (traded as NYSE:KREF.PR.A). However, I have yet to take a long position due to concerns about how the REIT would handle increasing interest rates. The price of the preferred shares has continued to decline, resulting in a yield of over 10%.
Checking up on the financial health of the REIT
KREF has experienced some challenges this year, with reported net income showing losses. Despite this, the net interest income in the second quarter was still decent at $44 million. However, the REIT had to allocate more than $56 million in loan loss provisions in addition to the $60.5 million allocated in the first quarter.
When looking at distributable earnings, they remain robust. In the second quarter, the total amount of distributable earnings was $33.07 million, which is consistent with the first quarter. This translates to distributable earnings per diluted share of $0.48. While this coverage is encouraging and current quarterly payments of $0.43 are fully covered, the book value per share is at risk of erosion. By retaining just $0.05 per share per quarter, the REIT retains just over $3 million in equity. This is insufficient to protect the balance sheet, especially considering the consistent high loan loss provisions.
Despite these challenges, I am positive about the exposure to multifamily properties. One of the assets, located in West Hollywood, California, has received a risk rating of 4 by KREF. Although property values have decreased due to increasing capitalization rates, I believe it is easier to market, remarket, and refinance multifamily properties compared to office portfolios.
The preferred shares: The preferred dividend is still covered
KR Real Estate Finance Trust has only one series of preferred shares available, which were issued in April 2021. These cumulative preferred shares were issued at $25 per share with a preferred dividend yield of 6.5%, resulting in annual preferred dividends of $1.625 per share. The preferred dividends are paid in four equal quarterly installments of $0.40625, and the yield will remain unchanged as long as the shares are outstanding.
While the preferred shares can be called by KKR Real Estate Finance Trust from April 2026 onwards, I do not expect them to be called given the current market situation and cost of capital. Therefore, analyzing the yield to call perspective is not useful in this case. The preferred shares are currently trading at $16.35, resulting in a yield of 9.95%. This yield is attractive, but it is important to assess the asset coverage ratio and the preferred dividend coverage ratio to ensure their strength.
The preferred dividend coverage level is strong, as the distributable earnings already include the quarterly preferred dividends. This means that less than 15% of the distributable earnings are needed to cover the preferred dividends. Based on this metric, the preferred shares are definitely interesting.
However, my main concern with KKR Real Estate Finance Trust is the asset coverage ratio. While dealing with loan loss provisions is a normal part of business, the lack of substantial earnings retention has led to significant erosion. In the first half of the year, the REIT allocated $117 million to loan loss provisions while generating only $7 million in retained earnings. This resulted in a decrease of approximately $112 million in total equity on the balance sheet. Meanwhile, $59 million was paid out in dividends on common shares. Suspending the dividend and retaining all distributable earnings could have reduced the impact on the book value by 50%. However, this is not a popular move and tends to be seen as a last resort.
At the end of Q2, the total equity value on the balance sheet was $1.46 billion, with $328 million in preferred equity. This left a total value of common equity at $1.13 billion, or $15.07 per share. This is substantially lower than the $16.56 per share at the end of last year. Fortunately, preferred shareholders are less affected by these losses, as common shareholders bear the brunt. However, with the rate of losing $100 million per semester, this cushion is decreasing rapidly.
Investment thesis
Given the high loan loss provisions, I am not interested in the common equity at the moment. I believe it would be better to lower the distribution and use the earnings to stabilize the balance sheet. While some investors may highlight the excellent distributable earnings and the positive correlation with interest rates, this becomes irrelevant when equity erosion is occurring. While earnings may increase, the value of loans is decreasing faster than dividend income is generated.
The preferred shares, currently yielding almost 10%, are somewhat safer but still speculative. A dividend cut on the common shares would be beneficial for the preferred shares, as it would slow down or stop the erosion of equity on the balance sheet. Additionally, preferred shareholders may benefit from lower interest rates, as they would not be impacted by lower earnings on common shares, and the share price of preferred shares would increase as yields decrease.
In summary, I am avoiding the common shares and currently have no position in the preferred shares. However, from a speculative point of view, the preferred shares are the only security I would consider.
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