KKR Real Estate Finance Trust (KREF) - 2018 Q4 - Annual Report

Part I Item 1. Business KKR Real Estate Finance Trust Inc. (KREF) is a real estate finance company externally managed by an affiliate of KKR, primarily originating and acquiring senior loans secured by institutional-quality commercial real estate - KREF is a real estate finance company focused on originating and acquiring senior loans for institutional-quality commercial real estate (CRE), operating as a REIT[18][21] - The company is externally managed by KKR Real Estate Finance Manager LLC, an indirect subsidiary of KKR & Co Inc, which provides significant advantages in sourcing, underwriting, and managing investments[20][23] Portfolio Growth (2016-2018) | Metric | 2016 | 2017 | 2018 | | :--- | :--- | :--- | :--- | | Portfolio Value | $944.5 million | $2,089.6 million | $4,133.5 million | | Origination Volume | $638.0 million | $1,476.1 million | $2,728.6 million | | Net Income | $31.1 million | $58.8 million | $87.3 million | | Book Value | $497.7 million | $1,059.1 million | $1,132.3 million | - As of December 31, 2018, the loan portfolio was highly diversified by property type and geography, with a focus on Office (45%) and Multifamily (32%) properties, and a significant concentration in New York (26%) and California (12%)[35][36] Financing Arrangements as of December 31, 2018 | Financing Type | Outstanding Principal (in thousands) | Maximum Capacity (in thousands) | | :--- | :--- | :--- | | Master repurchase agreements | $1,157,261 | $2,000,000 | | Asset specific financing | $60,000 | $200,000 | | Term loan financing | $748,414 | $1,000,000 | | Revolving credit agreements | $0 | $100,000 | | Collateralized loan obligations | $810,000 | $810,000 | | Total Portfolio Financing | $2,928,710 | $4,263,035 | - The company's business model is positioned to benefit from rising interest rates, as 98% of its investments by total assets earn interest over a floating-rate index as of year-end 2018[45] Item 1A. Risk Factors The company faces various risks across lending, operations, financing, its relationship with KKR, REIT status, and common stock ownership Risks Related to Lending and Investment Activities The company operates in a highly competitive real estate lending market and faces credit risks from subordinated debt and portfolio concentration - The company operates in a highly competitive market, competing with other REITs, banks, and private funds, which may limit its ability to source desirable investments at attractive yields[57] - Investments in subordinated instruments like CMBS B-Pieces, mezzanine loans, and preferred equity carry a greater risk of loss, as they are junior in the capital structure and would absorb losses before senior debt holders[62][63][64] - The Dodd-Frank Act's risk retention rules for CMBS transactions may limit investment opportunities, reduce market liquidity, and require holding CMBS B-Piece investments for at least five years without hedging, increasing risk[89][90] - The portfolio may be concentrated by geography, asset type, or sponsor, which exposes the company to increased risk of loss from localized economic downturns or issues with a specific asset class[86][87] Risks Related to Our Company Operational risks include reliance on KKR's systems, the need to avoid Investment Company Act registration, and potential regulatory changes - The company relies heavily on KKR's financial, accounting, and data processing systems, making it vulnerable to operational disruptions from system failures or cyberattacks[120] - To avoid registration as an investment company under the Investment Company Act, the company must adhere to strict asset composition tests (e.g., the 40% test), which limits investment flexibility and may hinder profit maximization[127][129][130] - Potential changes in financial regulations, such as amendments to the Dodd-Frank Act, could decrease restrictions on banks and other institutions, thereby increasing competition for the company[137][138] - As an "emerging growth company," KREF is subject to reduced reporting requirements, which may make its common stock less attractive to some investors[146] Risks Related to Financing and Hedging The company's use of leverage, particularly repurchase agreements, and the transition away from LIBOR pose significant financial risks - The company's use of leverage, particularly through repurchase agreements, subjects it to significant risks, including margin calls if collateral values decline, restrictive covenants that limit operational flexibility, and potential loss of assets upon default[147][152][154] - The planned cessation of LIBOR after 2021 creates uncertainty and risk, as a transition to a new benchmark rate like SOFR could increase interest expenses and adversely impact the value of LIBOR-linked assets and liabilities[162][163] - Hedging activities, while intended to mitigate risk, may be imperfect, costly, and expose the company to counterparty risk, potentially leading to unexpected losses[167][168][170] Risks Related to Our Relationship with Our Manager and Its Affiliates The company's dependence on its external Manager and inherent conflicts of interest with KKR pose significant governance and operational risks - The company is entirely dependent on its external Manager, an affiliate of KKR, and its key personnel for success, with termination of the management agreement being difficult and costly[177][179] - Significant conflicts of interest exist due to the relationship with KKR, including the allocation of investment opportunities, determination of fees, and potential for competitive or adverse activities[186][187][189] - The Manager's fee structure, including base management and incentive fees, may incentivize strategies that are not optimal for stockholders, such as increasing equity or taking on riskier investments to boost short-term earnings[184][185] Risks Related to REIT Status and Tax Considerations Failure to maintain REIT status would result in significant tax liabilities and operational constraints, potentially hindering profit maximization - Failure to maintain qualification as a REIT would result in being taxed as a regular corporation, leading to a substantial tax liability and a reduction in cash available for distribution to stockholders[195] - Compliance with REIT requirements may force the company to liquidate or restructure otherwise attractive investments to meet asset tests, or to distribute cash when it is not advantageous, potentially hindering profit maximization[198][199] - The company may generate "phantom income" where taxable income exceeds cash flow, particularly from debt instruments with original issue discount (OID), making it difficult to meet the 90% distribution requirement without selling assets or borrowing[207][208][209] - The company's charter limits stock ownership to 9.8% for any single person to protect its REIT status, which could also discourage takeovers beneficial to stockholders[202][203] Risks Related to Ownership of Common Stock KKR's controlling interest and anti-takeover provisions may not align with the interests of all stockholders - KKR controls the company through its 38% beneficial ownership and special voting preferred stock, which gives it the power to elect a majority of the board, potentially conflicting with other stockholders' interests[226] - KREF is a "controlled company" under NYSE rules, which exempts it from certain corporate governance requirements, such as having a majority of independent directors on its board[227][228] - Provisions in the company's charter, bylaws, and Maryland law, such as advance notice requirements and the Maryland Business Combination Act, may deter takeover attempts and limit stockholders' ability to sell shares at a premium[230][232][233] Item 1B, 2, 3, and 4 The company reports no unresolved staff comments, its principal executive offices are leased, and there were no material legal proceedings as of December 31, 2018 - Item 1B. Unresolved Staff Comments: None[252] - Item 2. Properties: Principal executive offices are located in leased office space in New York, NY[253] - Item 3. Legal Proceedings: No material legal proceedings as of December 31, 2018[254] - Item 4. Mine Safety Disclosures: Not applicable[255] Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities KREF common stock trades on the NYSE, with regular quarterly distributions and a share repurchase program approved in May 2018 Dividends Declared per Share (2017-2018) | Year | Q1 | Q2 | Q3 | Q4 | Total | | :--- | :--- | :--- | :--- | :--- | :--- | | 2018 | $0.40 | $0.43 | $0.43 | $0.43 | $1.69 | | 2017 | $0.35 (A) | $0.28 (A) | $0.25 | $0.37 | $1.62 | - In May 2018, the board approved a share repurchase program authorizing up to $100.0 million of common stock repurchases through June 30, 2019[267] Share Repurchases (Q4 2018) | Period | Total Shares Purchased | Average Price Paid per Share | Total Cost (in thousands) | | :--- | :--- | :--- | :--- | | Oct 2018 | 414 | $19.50 | $8 | | Nov 2018 | 0 | - | $0 | | Dec 2018 | 925,959 | $19.12 | $17,700 | | Total Q4 | 926,373 | $19.12 | $17,708 | Item 6. Selected Financial Data The company demonstrated significant growth from 2015 to 2018, with total assets reaching $4.15 billion and net income increasing to $87.3 million Selected Financial Data (2015-2018, in thousands except per share data) | Metric | 2018 | 2017 | 2016 | 2015 | | :--- | :--- | :--- | :--- | :--- | | Total Net Revenue | $118,651 | $79,609 | $41,195 | $22,310 | | Net Income Attributable to Common Stockholders | $87,293 | $58,818 | $31,141 | $16,748 | | Diluted EPS | $1.58 | $1.30 | $1.61 | $1.95 | | Dividends declared per share | $1.69 | $1.62 | $1.22 | $0.73 | | Total Assets (at period end) | $4,151,590 | $2,137,967 | $951,829 | $420,090 | | Total KREF Stockholders' Equity (at period end) | $1,132,342 | $1,059,145 | $497,698 | $281,460 | | Book value per share | $19.66 | $19.73 | $20.60 | $20.78 | | Leverage ratio | 2.6x | 1.0x | 0.7x | 0.3x | Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations In 2018, KREF achieved significant portfolio growth to $4.1 billion, with Net Core Earnings rising 91% and a strategic shift towards non-mark-to-market financing 2018 Highlights Key achievements in 2018 include substantial growth in net income and core earnings, significant investment activity, and strategic financing diversification - Operating Results: Net Income grew 48% to $87.3 million, and Net Core Earnings increased 91% to $105.9 million[277] - Investment Activity: Originated 19 floating-rate senior loans totaling $2.7 billion in commitments, with the current portfolio growing 98% to $4.1 billion and being 100% performing[277] - Portfolio Financing: Increased borrowing capacity to $4.1 billion and shifted financing mix so that 60% of asset-based financing is non-mark-to-market, primarily through a new $1.0 billion term loan facility and a $1.0 billion CLO[277] - Capital Markets: Issued $143.8 million in convertible notes, raised $107.7 million in net proceeds from primary share offerings, and repurchased $31.3 million of common stock[277] Key Financial Measures and Indicators This section reconciles GAAP Net Income to Net Core Earnings and presents key per-share metrics GAAP Net Income to Net Core Earnings Reconciliation (Year Ended) | (in thousands) | 2018 | 2017 | | :--- | :--- | :--- | | Net Income Attributable to Common Stockholders | $87,293 | $58,818 | | Non-cash equity compensation expense | $1,973 | $65 | | Incentive compensation to affiliate | $4,756 | $0 | | Unrealized (gains) or losses | $4,461 | ($3,375) | | Non-cash convertible notes discount amortization | $224 | $0 | | Reversal of previously unrealized gain now realized | $11,900 | $0 | | Core Earnings | $110,606 | $55,508 | | Less: Incentive compensation to affiliate | ($4,756) | $0 | | Net Core Earnings | $105,850 | $55,508 | - Book value per share was $19.66 as of December 31, 2018, compared to $19.73 as of December 31, 2017[287] Our Portfolio The investment portfolio grew to $4.1 billion, with a high proportion of floating-rate loans and strong credit quality - The investment portfolio grew to a value of $4.1 billion as of December 31, 2018, with 99% of loans by total loan exposure earning a floating rate of interest[288][289] Loan Portfolio Statistics (as of Dec 31, 2018) | Metric | Total Loan Portfolio | | :--- | :--- | | Number of loans | 41 | | Principal balance (in thousands) | $4,093,868 | | Unfunded loan commitments (in thousands) | $419,485 | | Weighted-average all-in yield | 6.5% | | Weighted-average max maturity (years) | 3.7 | | LTV | 69% | - The company uses a 5-point internal risk rating scale for its loans, with 100% of the loan portfolio rated 3 (Average Risk) or better as of December 31, 2018, and an average risk rating of 2.9[302][309] Results of Operations Net interest income significantly increased in 2018 due to portfolio expansion, while operating expenses rose primarily from incentive compensation and management fees Results of Operations Comparison (in thousands) | | 2018 | 2017 | | :--- | :--- | :--- | | Total net interest income | $98,558 | $61,921 | | Total other income (loss) | $20,093 | $17,688 | | Total operating expenses | $28,914 | $18,428 | | Net Income Attributable to Common Stockholders | $87,293 | $58,818 | - Net interest income increased by $36.6 million (59.2%) in 2018 compared to 2017, primarily due to a $1.6 billion increase in the weighted-average principal balance of the loan portfolio[344][345] - Total other income increased by $2.4 million, driven by a $13.0 million realized gain from the sale of CMBS B-Pieces, largely offset by a $13.3 million decrease in income from CMBS B-Pieces[347] - Total operating expenses increased by $10.5 million, mainly due to $4.8 million in incentive compensation incurred in 2018 (vs none in 2017) and a $2.9 million increase in management fees from a larger equity base[348] Liquidity and Capital Resources The company maintains strong liquidity through diverse funding sources, including equity, repurchase facilities, CLOs, and convertible notes - Primary sources of liquidity include equity issuances, repurchase facilities, CLOs, convertible notes, and cash flows from operations, with cash and cash equivalents at $86.5 million as of December 31, 2018[355] Leverage Ratios | Ratio | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Debt-to-equity ratio | 1.1x | 0.8x | | Total leverage ratio | 2.6x | 1.0x | - Net cash used in investing activities was approximately $2.0 billion in 2018, primarily to fund $2.5 billion in new loan originations, offset by $446.3 million in principal repayments and $112.7 million in proceeds from CMBS sales[363] - Net cash provided by financing activities was $1.9 billion in 2018, driven by $2.3 billion in proceeds from secured financing, $810.0 million from the CLO issuance, and $139.4 million from convertible notes, offset by $1.3 billion in debt repayments and $89.2 million in dividend payments[364] Item 7A. Quantitative and Qualitative Disclosures About Market Risk The company manages credit, interest rate, and financing risks, benefiting from rising interest rates due to its predominantly floating-rate investment portfolio - The company is exposed to credit risk from potential borrower defaults, which is monitored by the Manager through regular reviews of collateral performance and sponsor financial health[388] - The company's net income is positively correlated with interest rates, with a 50 basis point increase in short-term interest rates as of December 31, 2018, projected to increase annual cash flows by approximately $4.4 million[391][392] - Financing risk is a key concern, as weakness in financial markets could affect lenders' willingness to provide financing, which the company mitigates by diversifying its financing sources, including repurchase facilities, term loans, and CLOs[394] Item 8. Financial Statements and Supplementary Data This section presents the audited consolidated financial statements for 2016-2018, including balance sheets, income statements, equity changes, cash flows, and detailed notes on accounting policies and debt obligations Consolidated Balance Sheet Highlights (in thousands) | | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Total Assets | $5,231,845 | $7,394,893 | | Commercial mortgage loans, held-for-investment, net | $4,001,820 | $1,888,510 | | Total Liabilities | $4,096,657 | $6,331,709 | | Secured financing agreements, net | $1,951,049 | $964,800 | | Collateralized loan obligation, net | $800,346 | $0 | | Convertible notes, net | $137,688 | $0 | | Total KREF Stockholders' Equity | $1,132,342 | $1,059,145 | Consolidated Statement of Income Highlights (in thousands) | | 2018 | 2017 | 2016 | | :--- | :--- | :--- | | Total net interest income | $98,558 | $61,921 | $25,227 | | Total other income (loss) | $20,093 | $17,688 | $15,968 | | Total operating expenses | $28,914 | $18,428 | $8,569 | | Net Income (Loss) Attributable to Common Stockholders | $87,293 | $58,818 | $31,141 | - Subsequent to year-end, KREF originated one new senior loan for $76.0 million, funded $28.4 million under existing loans, received $297.8 million in loan repayments, and repurchased $4.1 million of its common stock[620][622][623][626] Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There were no changes in or disagreements with accountants regarding accounting and financial disclosure - None[634] Item 9A. Controls and Procedures Management concluded that the company's disclosure controls and internal control over financial reporting were effective as of December 31, 2018 - Management concluded that the company's disclosure controls and procedures were effective as of December 31, 2018[636] - Management concluded that the company's internal control over financial reporting was effective as of December 31, 2018[639] Part III Item 10, 11, 12, 13, 14 Information for Items 10 through 14 is incorporated by reference from the company's definitive proxy statement, to be filed with the SEC - The information for Items 10, 11, 12, 13, and 14 is incorporated by reference from the company's definitive proxy statement[645][646][647][648][649] Part IV Item 15. Exhibits, Financial Statement Schedules This section lists all financial statements, schedules, and exhibits filed as part of the Form 10-K, including corporate governance and financing agreements - This item lists all financial statements, schedules, and exhibits filed with the annual report[650] Item 16. Form 10-K Summary No Form 10-K summary was provided - None[659]