- ARI is a commercial mortgage REIT with an interesting loan portfolio.
- ARI has a fantastic total return performance.
- Earnings per share dilution due to recursive new share emission to pay dividends.
- Unsustainable dividend yield from operating activities.
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Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) is a commercial mortgage REIT (cm-REIT) whose stock market price has shown low volatility jointly with very high dividend yield. These are two exciting characteristics for all investors looking for a bond-like asset in a world of ultra-low interest rates. ARI is an enticing source of income and a valid way to diversify portfolio, but the dividend yield is unsustainable in the long term.
ARI is a commercial mortgage REIT (cm-REIT) externally managed by ACREFI Management, LLC (the Manager) an indirect subsidiary of Apollo Global Management, Inc. a leading global alternative investment company with a contrarian and value-oriented investment approach in private equity, credit, and real estate.
ARI tries to mitigate the conflict of interest between managers and shareholders adopting a minimum equity ownership guidelines requiring each independent director to maintain a minimum number of shares of Common Stock having a market value equal to or greater than a multiple of three times such independent director's annual cash retainer (excluding any portion of the retainer fee representing additional compensation for being a committee chairman). These mandatory ownership guidelines are intended to create a clear standard that encourages independent directors to remain invested in the performance of stock prices.
Under the Management Agreement, ARI pays the Manager (who is Apollo Global Management, Inc.) a management fee equal to 1.5% per annum of stockholders' equity, calculated and payable (in cash) quarterly in arrears.
The ARI's executive officers are employees of Apollo Global Management, Inc. or one of its affiliates, and therefore does not exist any agreement of compensation of executive officer different to salary. The total average compensation paid to executive officers each year is the 0.15% of the management fee paid by ARI to the Manager, and to grant the interest of the shareholders, that compensation is approximately 17% fixed (i.e., annual base salary), and approximately 83% is variable or incentive pay (i.e., bonus). In 2018, the total compensation of executives was $2,756,000. These facts suggest that despite the externally managed model run by the firm, the policy of managers' compensation reduces the conflict of interest between managers and shareholders as an internally managed REIT.
The ARI's primary objective is to rely on the Manager and its affiliates to seek any opportunity of investment that integrates real estate experience with private equity and capital markets expertise, in transaction sourcing, underwriting, execution, asset operation, management, and disposition. The ARI expectation is the continuation of capital deployment through the origination and acquisition of performing commercial first mortgage loans, subordinate financing and other commercial real estate-related debt investments at attractive risk-adjusted yields. ARI targets assets that are secured by institutional quality real estate throughout the United States and Europe.
As a part of the financing strategy, ARI uses financial leverage borrowing from primary investment banks and international financial institutions to invest the funds in target investments to gain from the interest spread.
Figure 1. The total return performance of ARI common stock compared to the S&P500 index and BBREMTG index representing a pool of mortgage REIT. Source: Apollo Commercial Real Estate Finance 10-K.
|TR performance||ARI||S&P 500 index||BBREMTG index|
The performance of ARI is due to 4 key factors:
- Apollo Global Management Sponsorship
- Differentiated Origination and Underwriting Capabilities
- A stable and diverse portfolio
- Prudent Balance sheet management
In brief, the first key factor relies on the expertise and to the size of the Manager (AUM of $331 Billion) which allows synergies in the capital deployment for investments; the second key factor refers to the ability of ARI to structure complex transactions with other partner and with Apollo vehicles and to participate in larger loans; the third key factor consider the portfolio of $6.38 Billion of loans secured by properties in U.S. and European gateway cities, the institutional quality of properties and the focus on senior loan; the last point considers the conservative leverage expressed by a debt to equity ratio at 1.4 accompanied to huge liquidity and ability to access to diversified capital sources.
On Dec. 31, 2019, ARI's 10-K form reported a net loan portfolio of $6.40 Billion yielding a weighted average coupon of 7.4%. The 83.54% of the loan portfolio is composed of commercial mortgage loans yielding 6%, the remaining 16.46% of the portfolio are subordinated loans and other lending assets yielding 14.1%.
During 2019, ARI paid interest expenses at 3.3% to funding loan portfolio. As such, the firm has a positive interest margin spread of 4.1% with a weighted average term of 3.3 years for the whole portfolio. The average LTV is 65%.
During the past 4 years, the portfolio has viewed both growth in size and an improvement in diversification.
Figure 2. ARI loan portfolio composition. Source: Apollo cm-REIT.
Noteworthy that the geographic diversification points out to concentrate loans collateralized by properties located in very attractive areas as New York City (Manhattan and Brooklyn), the Midwest and the West Coast. Not less important the rising international exposure in the UK and the rest of the EU.
Figure 3. ARI loan portfolio geographic and property type diversification. Source: Apollo cm-REIT.
ARI quarterly reviews the risk factors of each loan and assign a risk rating based on a variety of factors, including, without limitation, LTV, debt yield, property type, geographic and local market dynamics, physical condition, cash flow volatility, leasing and tenant profile, loan structure and exit plan, and project sponsorship. Based on a 5-point scale, loans are rated "1" through "5," from less risk to greater risk. The weighted average risk rating is equal to 3.0 in 2019 and 2018.
Interest rate risk
The movements of interest rates are the bigger factor impacting on the performance of mREIT. The manager of ARI attempted to hedge this risk mainly through structuring of the financing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods, using hedging instruments, interest rate swaps to the extent available, and using securitization financing to better match the maturity of its financing with the duration of its assets.
Moreover, it should be considered that the 95% portfolio is composed of floating rate loans certain of which are subject to a LIBOR floor. In particular, a hypothetical variation of +0.50% in interest rates causes an increase in net interest income per share of 0.06, while a variation of -0.50% reduces the net interest income per share by -0.02. Looking at the past performance of the firm, it seems that ARI has succeeded to manage very well the interest risk because the net interest income has not been heavily affected by interest rate swing.
The last ARI's 10-K form shows the operating results for the past five years. The most remarkable cash flow in this business is the gross interest income that has been growing by a CAGR of 20.46% passing from $192 Million (2015) to $487 Million (2019); the interest expenses averaging for each year 25% of gross interest income. Net interest income increases from $143 Million (2015) to $334 Million (2019) scoring a CAGR of 18.47%. The ratio between net interest income and gross interest income ranges in a band value between 0.68 and 0.76. The average ROE for each year since 2015 is 8%.
ARI's total assets are partially funded throughout debt for $4.17 Billion (whose 74% are credit facilities lent by six different major banks; noteworthy that around 50% of the loan portfolio is funding through credit facilities with a weighted average maturity of 3 years. Credit facilities are approved with counterparts for a total of $4.33 Billion but utilized for 72%). The effective weighted average cost of debt is around 6.32% (net of passive interest deductions). The remaining part of financing is represented by equity and the book value is $2.63 Billion. The cost of equity is 4.50%. So, ARI's WACC is 5.61%.
Analyzing the statement of cash flow, we can see that cash provided by operating activities $273 Million (2019), $266 Million (2018) remains above the 85% of gross interest income but a portion of this cash flow (minimum 90%) has to be paid to shareholders. That said, the investment activities of $1,435 Million (2019) and $999 Million (2018) were funded with new financing for $1,504 Million (2019), $765 Million (2018).
Right from cash flows from financing activities we can argue that every year, preferred and common dividend paid to shareholders has funded through issuance of common stocks causing dilution of earnings among shareholders; the EPS have been decreasing: 1.54 (2015), 1.74 (2016), 1.54 (2017), 1.48 (2018), 1.40 (2019). The falling trend in EPS consequently has led to the reduction of the book value per share: $20.47 (2015), $21.13 (2016), $19.49 (2017), $18.75 (2018), $17.13 (2019). Dividend per share was $1.78 (2015) and since 2016 raised to $1.84 appears too high. For the first time after many years, in March 2020 management declared a dividend per share of $0.40 to be paid quarterly - but it maybe should be cut further in the coming years. In my opinion, the stock price is sustained by the growth of the business, by ultra-low short-term interest rates which allow interesting positive net margin spreads and by high dividend yield appetite. However, the dilution of earnings can be a disappointing aspect for shareholders.
Change in stock price, Earnings per Share, Dividend per Share and number of shares outstanding for the period from 12/31/2015 to 12/31/2019.
Comparison among market price, book value per share and the outstanding number of shares during the last 4 years.
Asset-based valuation starts considering the ARI's loan portfolio of $6.4 Billion, the average maturity of 3.3 years, and expected interest income of $487 Million a year (this income is assumed equal to 12/31/2019 value of gross interest income), an annual growth rate of gross interest income equal to historical average (20.46%). To discount cash flow, I adopt the firm cost of debt equal to 6.32%.
Calculation gives a present value of loan portfolio slightly less than $7.08 Billion; subtracting the amount of $4.34 Billion of debt, comes out a value of equity of $2.75 Billion that divided by the current number of stocks outstanding, gives a value of equity per share equal to $17.84. Now, considering a hypothetical new issue of common stocks within the end of the current year, I say 20 Million of new common shares, other things remaining unchanged, we will have a stock price of $15.78 that is below the more recent book value of $17.13.
A value of $17.84 per share, given the book value of $17.13 returns a P/B ratio of 1.04. On 31st December 2019, the market price was a bit above at $18.29 corresponding to a P/B ratio 1.07.
Although in past years ARI showed growth in its portfolio size and an increase in net interest income, it should not be considered a bargain for long-term investment. That's because EPS has been diluting, the dividend yield is unsustainable, and consequently it's assured a future drop in market price. In my opinion, the better strategy for this stock is a speculative buy of a short/intermediate term, in which there is an opportunity to buy the common stock at a market price below or equal to book value. Then, you would hold the assets to collect dividends and sell the stock when the P/B ratio is beyond 1.10.
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