DBRS Morningstar Finalizes Provisional Ratings on KREF 2022-FL3 Ltd.

DBRS, Inc. (DBRS Morningstar) finalized its provisional ratings on the following classes of notes issued by KREF 2022-FL3 Ltd. (the Issuer):

-- Class A at AAA (sf)
-- Class A-S at AAA (sf)
-- Class B at AA (low) (sf)
-- Class C at A (low) (sf)
-- Class D at BBB (sf)
-- Class E at BBB (low) (sf)
-- Class F at BB (low) (sf)
-- Class F-E at BB (low) (sf)
-- Class F-X at BB (low) (sf)
-- Class G at B (low) (sf)
-- Class G-E at B (low) (sf)
-- Class G-X at B (low) (sf)

All trends are Stable.

The initial collateral consists of 16 floating-rate mortgage loans secured by 18 mostly transitional properties with a cut-off balance totaling $1.0 billion, excluding approximately $79.0 million of remaining future funding commitments and $981,993,471 of funded companion participations. The transaction is a managed CLO and is structured with a 24-month Reinvestment Period (and up to 60 days thereafter with respect to reinvestment collateral interests as to which the Issuer entered into binding commitments during the Reinvestment Period using principal proceeds received on, before or after the last day of the Reinvestment Period) whereby the Issuer may acquire Companion Participations in either the form of a mortgage loan, a combination of a mortgage loan and a related mezzanine loan, or a fully funded pari passu participation. In addition, the transaction is structured with a Replenishment Period, which begins on the first day after the Reinvestment Period and ends on the earlier of the date the Issuer acquired 10% of the cut-off balance after the Reinvestment Period and the sixth payment date after the Reinvestment Period. One loan, The Harland, representing approximately 4.0% of the Aggregate Collateral Interest Cut-Off Date Balance, has closed since DBRS Morningstar posted the presale report. Any Companion Participation acquired during either the Reinvestment Period or Replenishment Period is subject to Eligibility Criteria that, among other criteria, includes a no downgrade rating agency confirmation (RAC) by DBRS Morningstar for all new mortgage assets and funded Companion Participations. There are no B notes or mezzanine loans initially being held outside the trust for this transaction.

The loans are mostly secured by cash flowing assets, many of which are in a period of transition with plans to stabilize and improve the asset value. In total, eight loans, representing 62.9% of the pool, have remaining future funding participations totaling approximately $79.0 million, which the Issuer may acquire in the future subject to stated criteria. Please see the chart below for the participations that the Issuer may acquire once fully funded.

For the floating-rate loans, DBRS Morningstar used the one-month Libor index, which is based on the lower of a DBRS Morningstar stressed rate that corresponded to the remaining fully extended term of the loans or the strike price of the interest rate cap with the respective contractual loan spread added to determine a stressed interest rate over the loan term. When the debt service payments were measured against the DBRS Morningstar As-Is NCF, 11 loans, comprising 59.7% of the pool, had a DBRS Morningstar As-Is DSCR below 1.00x, a threshold indicative of elevated default risk. However, the DBRS Morningstar Stabilized DSCRs for only seven loans, representing 38.9% of the initial pool balance, are below 1.00x. The properties are often transitioning with potential upside in cash flow; however, DBRS Morningstar does not give full credit to the stabilization if there are no holdbacks or if other structural features in place are insufficient to support such treatment. Furthermore, even with the structure provided, DBRS Morningstar generally does not assume the assets to stabilize above market levels.

The transaction sponsor is KKR Real Estate Finance Trust (KREF), which is externally managed by KKR Real Estate Finance Manager LLC, a subsidiary of KKR & Co. KREF is a publicly traded commercial mortgage REIT focused primarily on originating and acquiring senior loans secured by institutional quality commercial real estate properties that are owned and operated by experienced and well-capitalized sponsors. Since its initial public offering in May 2017, KREF has originated $10.8 billion of loans and as of September 2021 had a portfolio balance of $5.8 billion.

The Class F, Class G, and Preferred Shares (collectively, the Retained Securities; representing 15.25% of the initial pool balance) will be purchased and retained by KREF 2022-FL3 Holdings LLC, a majority-owned affiliate of KKR Real Estate Finance Holdings L.P (KREF Holdings).

Four loans, representing 31.9% of the pool, feature sponsors that DBRS Morningstar has deemed Strong. Strong sponsorship correlates with more sophisticated borrowers, and loans with strong sponsorship generally exhibit lower rates of delinquency or default over the course of their loan terms.

The loan collateral was generally in very good physical condition. Eleven loans, representing 75.4% of the initial pool balance, were deemed Above Average (three loans, 23.0%) and Average + (eight loans, 52.4%) in quality, while the remaining 24.6% of the pool was deemed Average. No loans in the pool are backed by a property that DBRS Morningstar considered to be of Average –, Below Average, or Poor quality. More than 50% of the properties were recently built within the past five years.

The ongoing coronavirus pandemic continues to pose challenges and risks to the commercial real estate (CRE) sector, and the long-term effects on the general economy and consumer sentiment are still unclear. Fourteen loans (91.8% of pool) were originated in 2021 and one loan (4.0% of pool) was originated in 2022. The loan files are recent, including third-party reports that consider impacts from the coronavirus pandemic. Only one loan, The Kendrick, representing 4.2% of the initial pool balance, was originated prior to the onset of the pandemic.

All loans in the pool are secured by multifamily properties and all loans that may be acquired during the reinvestment period must also be secured by multifamily properties (including a maximum of 15% of the aggregate outstanding portfolio balance on student housing properties). Multifamily properties have historically seen lower PODs and typically see lower E/Ls within the DBRS Morningstar model. Multifamily properties benefit from staggered lease rollover and generally low expense ratios compared with other property types. While revenue is quick to decline in a downturn because of the short-term nature of the leases, it is also quick to respond when the market improves. Additionally, most loans in the initial pool are secured by traditional multifamily properties, such as garden-style communities or mid-rise/high-rise buildings, with no independent living/assisted-living/memory care facilities or student housing properties included in this pool.

Eleven loans, composing of 62.8% of the initial trust balance, represent acquisition financing. Acquisition loans are considered more favorable because the sponsor is usually required to contribute a significant amount of cash equity as part of the transaction, and it is also generally based on actual transaction values rather than an appraiser’s estimate of market value.

The DBRS Morningstar Business Plan Score (BPS) for loans DBRS Morningstar analyzed was between 1.4 and 2.5, with an average of 1.8. On a scale of 1 to 5, a higher DBRS Morningstar BPS indicates more risk in the sponsor’s business plan. DBRS Morningstar considers the anticipated lift at the property from current performance, planned property improvements, sponsor experience, projected time horizon, and overall complexity. Compared with similar transactions, this pool has a lower average DBRS Morningstar BPS, which is indicative of lower risk.

Three loans, representing 28.0% of the pool balance, have collateral in DBRS Morningstar MSA Group 3, which is the best-performing group in terms of historical CMBS default rates among the top 25 MSAs. DBRS Morningstar MSA Group 3 has a historical default rate of 17.2%, which is nearly 10.8 percentage points lower than the overall CMBS historical default rate of 28.0%.

The transaction is managed and includes a reinvestment period and a replenishment period, which could result in negative credit migration and/or an increased concentration profile over the life of the transaction. Eligibility criteria for reinvestment assets partially offsets the risk of negative credit migration. The criteria outlines DSCR, LTV, Herfindahl, and property type limitations. A no downgrade confirmation RAC is required from DBRS Morningstar for reinvestment loans and companion participations, allowing DBRS Morningstar the ability to analyze them for any potential ratings impact.

DBRS Morningstar has analyzed the loans to a stabilized cash flow that is, in some instances, above the in-place cash flow. It is possible that the sponsors will not successfully execute their business plans and that the higher stabilized cash flow will not materialize during the loan term, particularly with the ongoing coronavirus pandemic and its impact on the overall economy. A sponsor’s failure to execute the business plan could result in a term default or the inability to refinance the fully funded loan balance. DBRS Morningstar made relatively conservative stabilization assumptions and, in each instance, considered the business plan to be rational and the future funding amounts to be sufficient to execute such plans. In addition, DBRS Morningstar analyzes LGD based on the as-is credit metrics, assuming the loan was fully funded with no NCF or value upside.

All 16 loans in the pool have floating interest rates and are IO during the initial and extended loan term, creating interest rate risk and a lack of principal amortization. DBRS Morningstar stresses interest rates based on the loan terms and applicable floors or caps. The DBRS Morningstar Adjusted DSCR is a model input and drives loan-level PODs and LGDs. All loans except for one, Crystal Towers and Flats (12% of pool), have extension options, and, to qualify for these options, the loans must meet minimum DSCR and LTV requirements. All loans are short term and, even with extension options, have a fully extended loan term of five years maximum, which based on historical data, the DBRS Morningstar model treats more punitively. The borrowers for 11 loans, totaling 68.7% of the trust balance, have purchased Libor rate caps that range between 0.5% and 4.00% to protect against rising interest rates over the term of the loan.

Based on the initial pool balances, the overall DBRS Morningstar WA As-Is DSCR of 0.95x and DBRS Morningstar WA As-Is LTV of 77.3% generally reflect high-leverage financing. Most of the assets are generally well positioned to stabilize, and any realized cash flow growth would help to offset a rise in interest rates and improve the overall debt yield of the loans. DBRS Morningstar associates its LGD based on the assets’ as-is LTV, which does not assume that the stabilization plan and cash flow growth will ever materialize. The DBRS Morningstar As-Is DSCR at issuance does not consider the sponsor’s business plan, as the DBRS Morningstar As-Is NCF was generally based on the most recent annualized period. The sponsor’s business plan could have an immediate impact on the underlying asset performance that the DBRS Morningstar As-Is NCF does not account for. When measured against the DBRS Morningstar Stabilized NCF, the DBRS Morningstar WA DSCR is estimated to improve to 1.06x, suggesting that the properties are likely to have improved NCFs once the sponsor’s business plan has been implemented. The DBRS Morningstar WA Stabilized LTV is estimated to improve to 74.2%.

Two of the collateral interests, Aven and Portofino Place, representing 23.5% of the pool, are subject to an existing participation agreement entered in connection with the KREF 2021-FL2 offering, which sets forth the respective rights and obligations of the holders created under such KREF 2021-FL2 participation agreement and are nonserviced loans. In connection with the servicing of each such nonserviced loan, any special servicer under the lead servicing agreement (which, as of the Closing Date, will be the related special servicer under the KREF 2021-FL2 servicing agreement or participation agreement, intercreditor agreement, or co-lender agreement, as applicable) may take actions with respect to such loan that could adversely affect the holders of some or all of the classes of notes. The rights of the holders of the nonserviced loans are each governed by a co-lender and agency agreement, which provides the other noteholder with control, subject to certain consent rights, and appoints that party as administrative agent subject to a gross negligence standard for liability and indemnification in dealing with noteholders. The in-place servicing agreement follows securitization standards.

Because of health and safety constraints associated with the ongoing coronavirus pandemic, DBRS Morningstar was unable to perform in-person site inspections on any of the properties in the pool. As a result, DBRS Morningstar relied more heavily on third-party reports, online data sources, and information provided by the Issuer to determine the overall DBRS Morningstar property quality of each loan. The Issuer provided recent third-party reports for all loans that contained property quality commentary and photos except for the PCR and Phase I reports for The Kendrick, which was prepared more than 12 months ago.

One loan, secured by The Kendrick, representing 4.2% of the pool balance, has an open environmental issue, first identified after the loan’s origination, involving levels of trichloroethylene (TCE), a potentially carcinogenic substance, in indoor air and soil gas exceeding regulatory limits. The matter is subject to a mandated in process (early stage) regulatory order by the Massachusetts Department of Environmental Protection (MassDEP) to investigate and remediate the identified contamination until fully resolved potentially over an estimated five-year timeline. DBRS Morningstar was advised that MassDEP’s immediate response required an assessment of the subslab depressurization system at the property (SSDS), temporary installation of air purifying units in certain units, and a design (and installation) of a new SSDS. The sponsor also advised that it would be required to obtain a revised Phase I assessment by June 2022, a Phase II assessment by June 2025, and depending on the results, the implementation of a Phase IV remedy plan by June 2026, with the potential finalization of a solution by June 2027. Currently, 18 of the units identified as affected are considered down units and are concluded as vacant by DBRS Morningstar.

DBRS Morningstar was further advised that the sponsor’s compliance with the MassDEP remediation steps is under way and approximately $1.5 million has been spent to date as part of that investigation and remediation, with the new SSDS expected to be installed by March 2022. In addition, an investigation of the surrounding area is planned to determine whether other parties responsible for offsite sources or environmental releases could be causing or contributing to these issues and whether they should share in the investigation and remediation costs.

The uncertainty of the source of the TCE, unknown scope of its physical and intangible impact, and extended timeline for investigating, remediating, and monitoring (in accordance with a regulatory order) create a potential credit risk not only as to the anticipated hard cost expense to investigate and remediate, which the sponsor’s environmental consultant estimated at $14.5 million in a worst-case scenario, but also as to the potential risk of diminution in value created by such cost and the possible stigma and potential liability associated with the presence of a known environmental hazard at the property. In any event, this ongoing unresolved issue could adversely affect occupancy and cash flow and result in a term default, or the potential inability to refinance the fully funded loan or to sell the property in a situation where the trust may not be able to enforce remedies against the property because of an unresolved environmental issue.

The borrower sponsors provided an environmental indemnity in connection with the loan and are required to take action should an environmental event occur per the Loan Document. The borrower sponsors have reportedly spent $1.5 million to date and have provided a joint and several environmental indemnity in connection with the related mortgage loan and are motivated to fully remediate the property. DBRS Morningstar NCF analysis excluded the 18 down units. In addition, DBRS Morningstar adjusted the As-Is and As-Stabilized appraised values downward and increased the LGD on this loan given the amount of potential risks involved and the open-ended nature of this environmental issue. As a result of these adjustments, the loan’s expected loss increased to be over the pool WA. The sponsors on this loan, Toll Brothers and Ares Management, are publicly traded companies and institutional sponsors. Both Toll Brothers and Ares US Real Estate Development and redevelopment Fund II, LP, are the nonrecourse carveout guarantors on this loan.

As the deadline for the elimination of Libor approaches, the interest rate on the Notes will initially be based on the floating rate benchmark, Term SOFR (defined as the one-month forward-looking term rate, as obtained by the Calculation Agent, identified as 1 Month CME Term SOFR). However, because Term SOFR is a relatively new index and different kinds of SOFR-based rates exist, mismatches between SOFR-based rates and other benchmark-based rates may cause economic inefficiencies and cause the Notes to experience significant volatility and fluctuations. Also, Term SOFR may not become unavailable and may change upon the occurrence of a benchmark transition event and its related benchmark replacement date.

In addition, all of the Closing Date Real Estate Loans will initially bear (or are expected to bear) interest at adjustable rates based on Libor for one-month Eurodollar deposits. To the extent the Issuer acquires Collateral Interests in the future, or if the Closing Date Real Estate Loans are modified by permitted Administrative Modifications, it is expected that such Collateral Interests will bear interest at adjustable rates based on Term SOFR, Libor for one-month Eurodollar deposits, or other SOFR benchmark. Several potential mismatches including (i) basis mismatch between the Notes and the Collateral Interests as a result of interest rates that are based on different accrual periods, (ii) timing mismatch between the Notes and the Collateral Interests as a result of the benchmark on such Collateral Interests adjusting on different dates than the benchmark on the Notes; (iii) mismatch that results from some or all of the Collateral Interests converting (a) to an alternative rate to Term SOFR that is different from the Benchmark Replacement determined in accordance with the terms of the Indenture, (b) at a different time than when the Notes convert to any Benchmark Replacement or (c) with a different spread adjustment than the applicable benchmark replacement adjustment or (iv) mismatch between the Benchmark and/or benchmark replacement adjustment on the Notes and the benchmark and/or the benchmark replacement adjustment (if any) applicable to the Collateral Interests or mismatch or unavailability of a comparable interest rate protection agreement could result in the Issuer not collecting sufficient interest proceeds to make interest payments on the Notes.

To compensate for differences between the successor Benchmark and then-current Benchmark, a benchmark replacement adjustment will be included in any benchmark replacement other than Term SOFR. However, any benchmark replacement adjustment may not be sufficient to produce the economic equivalent of the then-current Benchmark, either at the benchmark replacement date or over the life of the Notes. Currently, the Collateral Manager, will have sole discretion in all elements of the benchmark replacement process including loan-level benchmark conforming changes and modifications or waivers of interest protection agreements. Noteholders will not have any right to approve or disapprove of any changes as a result of any benchmark transition event and/or its related benchmark replacement date, the selection of a benchmark replacement or benchmark replacement adjustment or the implementation of any benchmark replacement conforming changes to the Loans. In the discharge of any Special Servicer Alternative Rate Activities (which includes (i) any action taken or omitted to be taken by the Special Servicer with respect to the implementation of any loan-level benchmark replacement and loan-level benchmark replacement conforming changes, (ii) updating Special Servicer’s servicing system for the related loan-level benchmark replacement and (iii) following the direction of the Collateral Manager regarding such loan-level benchmark replacement and loan-level benchmark replacement conforming changes) the Special Servicer will be held to a gross negligence standard only with regard to any liability for its actions.

Three loans, each having a loan balance greater than $20 million (Aven, The Kendrick, and Alvista Durham), combined representing 20.2% of the initial pool balance, were not required to obtain a nonconsolidation opinion as part of their loan agreement. As a result, there is no opinion provided as to the separateness of the borrower to the overarching sponsorship that could otherwise be looked to as an opinion of separateness during a bankruptcy proceeding. DBRS Morningstar applied a POD adjustment to these loans to account for the lack of a consolidation opinion.

In this transaction, Administrative Modifications and Criteria-Based Modifications may be directed by the sponsor-affiliated Collateral Manager, not subject to the Servicing Standard, but subject to a Collateral Manager Standard and the Eligibility Criteria (as adjusted for modifications). The Eligible Criteria Modification Adjustments include a provision stating that if any such modification does not involve an increase in the principal balance of the related mortgage loan, it does not require no downgrade confirmation from DBRS Morningstar.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

All ratings are subject to surveillance, which could result in ratings being upgraded, downgraded, placed under review, confirmed, or discontinued by DBRS Morningstar.

For supporting data and more information on this transaction, please log into www.viewpoint.dbrsmorningstar.com. DBRS Morningstar provides analysis and in-depth commentary in the DBRS Viewpoint platform.

Notes:
All figures are in U.S. dollars unless otherwise noted.

With regard to due diligence services, DBRS Morningstar was provided with the Form ABS Due Diligence-15E (Form-15E), which contains a description of the information that a third party reviewed in conducting the due diligence services and a summary of the findings and conclusions. While due diligence services outlined in Form-15E do not constitute part of DBRS Morningstar’s methodology, DBRS Morningstar used the data file outlined in the independent accountant’s report in its analysis to determine the ratings referenced herein.

The principal methodology is North American CMBS Multi-Borrower Rating Methodology (March 26, 2021), which can be found on dbrsmorningstar.com under Methodologies & Criteria. For a list of the structured-finance-related methodologies that may be used during the rating process, please see the DBRS Morningstar Global Structured Finance Related Methodologies document, which can be found on dbrsmorningstar.com in the Commentary tab under Regulatory Affairs. Please note that not every related methodology listed under a principal structured finance asset class methodology may be used to rate or monitor an individual structured finance or debt obligation.

The DBRS Morningstar Sovereign group releases baseline macroeconomic scenarios for rated sovereigns. DBRS Morningstar analysis considered impacts consistent with the baseline scenarios as set forth in the following report: https://www.dbrsmorningstar.com/research/384482/baseline-macroeconomic-scenarios-application-to-credit-ratings.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the rating process.

The full report providing additional analytical detail is available by clicking on the link under Related Documents below or by contacting us at [email protected].

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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