KKR Real Estate Finance: 14.5% Yield, 28% Discount To Book Value, Risky Environment

KKR Real Estate Finance Trust (NYSE:KREF) has dipped around 17% year-to-date with the gap between its common equity and book value deeply widening as investors fret over the impact of higher base rates on the mortgage REIT's portfolio of multifamily, industrial, and office loans. The CRE lending sector is currently under pressure with a Fed funds rate sitting at 5.25% to 5.50%, catalyzing an intensely difficult macro environment. KREF's commons are currently trading at a 28% discount to their book value of $16.38 per share as of the end of its fiscal 2023 second quarter with the mREIT's office exposure at 26% of its loan portfolio becoming suspect against a post-pandemic working from home zeitgeist.

For bears, the headwinds are clear with a book value that fell 4.5% sequentially from $17.16 per share in the prior first quarter. The first quarter itself was a quarter-over-quarter decline of 4.7% with rising CECL allowance driving near-term underperformance. The mREIT last declared a quarterly cash dividend of $0.43 per share, in line with its prior payment, and for a 14.5% annualized dividend yield. Is the current dividend yield safe against book value in decline? What's the outlook for the mREIT's loan portfolio, especially as office properties go through their starkest period of uncertainty in the contemporary history of capitalism?

KREF's Loan Portfolio

KREF's loan portfolio was valued at $7.87 billion as of the end of its second quarter and with a 56% allocation to multifamily and industrial properties. This came with a $126 million average loan size, with KKR (KKR) owning a 14% stake in the mREIT. There are a few things to note here. Firstly, total net interest income at $43.95 million fell 4.18% over its year-ago comp with a significant 160% increase in interest expense to $115.7 million versus a comparative 76% increase in interest income to $160 million driving the year-over-year underperformance for the second quarter.

The second quarter also saw provision for credit losses come in at $56.34 million, a 378% increase over its year-ago comp and around $0.82 per share. This line item covers defaults KREF expects to arise from its loan portfolio. Critically, this was the main factor that drove what was a net loss from operations of $25.77 million, a deterioration from KREF's year-ago quarter when it realized a profit of $19.39 million. To be clear, KREF's portfolio was flat year-over-year because the mREIT is moving a lot more defensively with its underwriting. KREF funded $177.2 million in loans during the second quarter against loan repayments of $339.3 million. This was with its cash and equivalents position swelling to $207.7 million from $118 million in its year-ago quarter. KREF also had $560 million of undrawn capacity on its revolving credit agreement.

The Discount Could Be Sticky But The Dividend Is Safe

The current discount to book is an anomaly driven by market angst over the direction of interest rates, the mREIT's office exposure, and a rising CECL provision. However, distributable earnings came in at $33.1 million or $0.48 per share. The mREIT's portfolio is also 99% comprised of floating rate loans with a prudent weighted average loan-to-value ratio of 65%. Whilst office represented 26% of the portfolio, the market has gone too far with its discounting of respective office-exposed REITs. Class A offices, which are higher quality and broadly more modern office buildings in prime locations, comprised 94% of these office loans. Critically, KREF's distributable earnings when set against its current double-digit dividend means the quarterly payout enjoyed a 111.6% coverage ratio.

The CECL provision for the quarter also amounted to 0.71% of the mREIT's loan portfolio. A sub 1% CECL provision and a rising cash balance as the mREIT moves more defensively could see book value stabilize in the coming quarters, especially against KREF's floating rate loans. I'd expect the Fed's higher for longer mantra to continue to drive continued volatility with CRE, but the more defensive stance of the mREIT and its growing multifamily portfolio, which benefited from a weighted average rent increase of 7.5% year-over-year during the second quarter, provide reasons for calm. I don't expect the dividend to change in the near term but continued uncertainty around the extent of the rightsizing of office real estate will continue to drive the commons to trade at a discount to their book value. I think the commons could come to represent a cautious buy if we see the book value stabilize in future quarters.