KKR Real Estate Finance Trust: 8.7% Yield On Preferred Shares (NYSE:KREF)
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While KKR Real Estate Finance Trust (NYSE:KREF) will only publish its financial results for the third quarter of this year next week Monday, I wanted to have a look at the company’s preferred shares which are trading with (NYSE:KREF.PA) as ticker symbol. While I understand the increasing interest rates on the financial markets will impact KREF’s performance, I think the preferred dividend payments should be fine and the recent decrease in the share price of the preferred shares to just $18.60 could be an opportunity.
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While waiting for the Q3 results to be published, let’s look back at the first semester
KREF’s bread and butter is investing in originating and acquiring transitional senior loans with commercial real estate as collateral. This means KREF is basically a mortgage REIT and those have been hit hard in the recent turmoil and it will definitely be interesting to see how KREF managed the choppy waters in the third quarter.
In this article I will mainly focus on the preferred shares but to know how interesting the preferred shares are, it is obviously important to check up on how the REIT is doing.
In the second quarter of the year, KREF reported an increase in the net interest income from just under $41M in the first quarter to almost $46M in the second quarter thanks to an increasing interest income and but with the caveat the interest expense increased at a slightly faster pace. On top of that the total ‘other income’ decreased from $6.4M to $4.1M mainly due to a lower revenue from investments.
The operating expenses increased dramatically but that was entirely caused by the provision for credit losses. As you can see in the image above, KREF recorded a $11.8M provision in the second quarter of the year, which essentially wiped out the $1.2M reversal recorded in the first quarter of the year.
The total income of the REIT was approximately $25M of which $5.3M had to be spent on the preferred dividends and $0.3M was attributable to the owners of ‘participating securities’. This means the bottom line showed a net income attributable to the owners of KREF of $19.4M for an EPS of $0.28. The total EPS in the entire first semester was $0.75 as the Q2 results were hit by that loan loss provision which had an impact of approximately 17 cents per share on the earnings. So while the dividend of $0.43 per quarter on the common shares currently isn’t covered by the earnings, it would still be covered once you exclude the loan loss provisions. That being said, the distributable earnings (which exclude the non-cash expenses related to loan loss provisions) are still sufficient to cover the current distributions.
The terms of the preferred shares issued by KREF
KREF has one series of preferred shares available, which were issued in April of last year. The company issued cumulative preferred shares at the normal price of $25 and with a preferred dividend yield of 6.5%. This means these securities are paying $1.625 per year in preferred dividends, in four equal quarterly installations of $0.40625 and the preferred dividend yield will remain unchanged for as long as these securities remain outstanding. KREF.PA can be called by KKR Real Estate Finance Trust from April 2026 on.
At the current share price of $18.60, the preferred shares offer a dividend yield of 8.74%.
Looking at the income statement of KREF in the second quarter, we see the preferred dividend was still very well covered. Despite recording in excess of $11M in loan loss provisions, KREF generated almost $25M in net income which obviously more than covered the $5.3M in preferred dividend payments. Even if the quarterly loan loss provision would double from here, the preferred dividend would still have a coverage ratio of in excess of 200%.
This brings us to the balance sheet to determine the asset coverage level.
As of the end of June, KREF had about $7.7B on its balance sheet of which $1.68B was equity. There are 13.11M preferred shares outstanding for a total value of just under $328M which means that approximately $1.35B of the equity on the balance sheet ranks junior to the preferred shares. As of the end of June, the asset coverage ratio exceeded 500% and that’s very decent.
This doesn’t mean these preferred shares are riskless. With an excess of $6B in liabilities on the balance sheet and a net debt position of almost $5.9B, KREF’s debt to equity ratio is relatively high. The REIT isn’t too worried as the average LTV ratio of its loans is approximately 67% and although that is relatively high, it means the $7.47B in senior loans on the balance sheet is backed by in excess of $11B in real estate assets .
That sounds great, but we still have to keep in mind that as interest rates move up, the capitalization rate used to value the underlying assets will go up as well. This will result in lower asset values and thus a higher LTV ratio, up to a level that some borrowers may be in default. Seeing how 10% of the loans have an LTV ratio of in excess of 75% isn’t exactly putting my mind at rest. I’m sure KREF’s teams are closely monitoring the developments but it’s not hard to see the valuation of commercial real estate assets being hit in an increasing interest rate environment.
There is also a small silver lining as an increase in the LIBOR & SOFR rates will boost the EPS. An increase of 200 base points will boost the annual income by $0.41 per share. Based on the current share count of 69.25 million shares, KREF would generate an additional $28M in earnings per year which could be used to boost the loan loss provision buffer.
While I usually like to have the most up-to-date financial results before deciding to initiate a long position in a stock or preferred share, I think I will initiate a small (and speculative!) long position in KREF’s preferred shares. Depending on how the Q3 results turn out (and if there’s any particular guidance for the fourth quarter of this year and/or 2023) I may either add to that position or just remain on the sidelines to wait for better visibility before adding to the initial speculative stake.
At this point, I am only focusing on the preferred shares as the distribution on the common units is quite aggressive and loan loss provisions are weighing on the bottom line results.