Apollo Commercial: External And Internal Difficulties But A 10.56% Yield

Daniel P. Varga profile picture
Daniel P. Varga
727 Followers

Summary

  • Apollo has a forward dividend yield of 10.56% with an 11-year consecutive dividend payment history.
  • ARI trades 20% below its tangible book value right now.
  • The company faces several difficulties relating to its core business model.
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Investment Thesis

Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) is facing difficulties in the short term and the management is open about them. ARI is facing higher prepayments than expected, capital efficiency issues, rising interest rates in 2022. However, the current valuation is attractive with prices 20% below the company’s tangible book value and it has the best figure among its competitors. In addition, the company has a 10.56% forward dividend yield which is appealing for income-seeking investors. I feel there is an equilibrium in the positive valuation and the negative fundamentals so I am not buying yet, but keeping close attention on ARI for the next couple of months.

Business Model

Apollo Commercial operates as a real estate investment trust (REIT) that originates, acquires, invests in, and manages commercial first mortgage loans, subordinate financing, and other commercial real estate-related debt investments in the United States. The company was awarded an Innovative, Creative Global CRE Debt Provider and has a twelve-year track record. ARI serves predominantly gateway markets throughout the United States and Western Europe with strong fundamentals. 61% of its loan portfolio is in the United States, the lion’s share of it is in New York (30%) where ARI has its headquarters. The rest of the loan portfolio is in Europe with 21% in the United Kingdom and approximately 17% in Spain, Italy, Germany, and Sweden. The investment portfolio went through a massive restructuring since 2015 and by Q3 2021 88% of the loans are first lien secured loans.

Source: Investor Presentation

Financials & Earnings

Q3 results

The company’s distributable earnings for the quarter were $49 million or $0.35 per share. The loan portfolio at quarter-end was $7.3 billion, a slight decline from the end of the previous quarter, due to increased loan repayments. Approximately 89% of its floating rate US loans have LIBOR floors that are in the money today with a weighted average floor of 1.20%. ARI made $180 million first mortgage, $141 million of which were funded. The company also made $113 million of add-on fundings for previously closed loans. ARI ended the quarter with almost $600 million of total liquidity, which was a combination of cash and capacity on its lines. Their debt to equity ratio at quarter-end decreased slightly to 2.2 times. Earnings per share estimate were $0.36 for Q3 but the actual number was $0.35 per share a slight $0.01 miss.

The strength of the CRE lending market has also led to more normalized repayment activity in their portfolio. Through September 30, the company has received almost $800 million of loan repayments and an additional $277 million of loans have been repaid since the quarter-end. ARI’s repayments reflect encouraging signs from the general economy as transitional assets are achieving their business plans including construction projects, achieving certificates of occupancy, and for-sale residential units being sold. As a result, ARI's construction exposure continues to decline representing approximately only 14% of the portfolio at quarter-end. The management also has seen positive anecdotes from their portfolio of loans securing office properties. 25% of ARI’s collateral portfolio is in office developments and buildings which can be a risk as the new variant spreads further and workers stay home. (We will discuss this part more in-depth in Risk Factors.)

Source: Investor Presentation

Valuation

A good indicator to see how undervalued or overvalued ARI is to check its book value to its current price. In addition, we can make a comparison with its similar market cap peers. ARI trades 20% below its tangible book value at the moment so according to this number the company is undervalued.

Chart
Data by YCharts

Looking at its peers’ price to TBV we can see a similarly undervalued company. Claros Mortgage Trust, Inc. (CMTG) which is a commercial mREIT with the same market cap as ARI trades 9% below its TBV. Broadmark Realty Capital Inc. (BRMK) is a residential and commercial mREIT but with approximately the same market cap as ARI. BRMK trades 22% above its tangible book value. Starwood Property Trust, Inc. (STWD) has a commercial part of its operations so we can make a comparison but this company is 3.5 times bigger than ARI, also has a rock-solid dividend history with no cuts (not even during the pandemic). STWD trades 69% above its TBV at the moment.

Source: Seeking Alpha

Company-specific Risks

A number of entities compete with ARI to make the types of investments that they target. There are 41 mREITs operating in the commercial and residential REIT market. There are external market changes that affect ARI but there are a few internal ones worth looking at.

ARI leverages certain of its target assets through secured debt arrangements. The return on their assets and cash available for distribution to stockholders may be reduced if market conditions cause the cost of their financing to increase relative to the income that can be derived from the assets acquired. In addition, their debt service payments will reduce the cash flow available for distributions to stockholders. Borrowing rates have been currently at historically low levels that may not be sustained in the long run. As their secured debt arrangements and other short-term borrowings mature, they will be required either to enter into new borrowings or to sell certain of their assets. An increase in short-term interest rates at the time that they seek to enter into new borrowings would reduce the spread between the returns on ARI’s assets and the cost of its borrowings.

In addition, because the company’s secured debt arrangements are short-term commitments of capital, lenders may respond to market conditions making it more difficult for ARI to secure continued financing. Because more than 35% of the company’s investment portfolio is abroad a major part of its borrowings are denominated in USD, GBP, EUR, and SEK. Potential changes or uncertainty related to changes may adversely affect the market for LIBOR-based securities, including the company’s portfolio of LIBOR-indexed, floating-rate debt securities. Although SOFR appears to be the preferred replacement rate for U.S. dollar LIBOR, at this time, it is not possible to predict the effect of any such changes, any establishment of alternative reference rates, or other reforms to LIBOR that may be enacted in the United States, United Kingdom or other parts of the world.

Changes in interest rates will affect ARI’s operating results as such changes will affect the interest the company receives on any floating rate interest-bearing assets and the financing cost of its floating rate debt, as well as ARI’s interest rate swap that the management may utilize for hedging purposes. Changes in interest rates can also affect borrower default rates, which may result in losses for ARI. At the moment the majority of Fed members forecast three interest rate hikes in 2022 to fight inflation.

There is an external risk factor that we should consider: the office occupancy rates will maybe never return to pre-COVID levels as work from home trends seem permanent with 25-30% of the employees are working from home exclusively. This can negatively affect the company’s office portfolio.

My take on ARI’s dividend

Current dividend

Apollo has been paying a consecutive dividend for 11 years only a bit below the 13-year sector median. The company had only increases (but not regular ones) until the pandemic but in 2020 the management had to cut the dividend twice. Since then the dividend is maintained at the same level of $0.35 per share quarterly. ARI has a forward dividend yield of 10.56% with no potential increases on the horizon for 2022.

Future sustainability

The future sustainability mainly depends on two factors: on the income that the management can distribute to shareholders and on the management’s dividend policy and willingness to return money to shareholders via dividends. ARI has been facing challenges in terms of its dividend but the management communicates about these issues openly:

“I think the EPS, which we out-earned, the dividend level which we out-earned in the first 2 quarters, I think we covered it in the third quarter. I think part of it depends on how capital efficient we are and doing the best we can to line up the combination of both repayments and new deployment. So I think long term, I think there is potential beyond the $0.35. But I think in the near term, we've got some challenges both in terms of capital efficiency and focused assets that we need to work through.” Stuart Rothstein, CEO of ARI.

In terms of the payout ratio, we can see that it is stretched to the limits, and with the pressure on future earnings, we cannot expect a dividend raise soon. But I value the CEO’s openness about the challenges they face in the short term. I think this pressure will be with the company in 2022 but I am fairly confident they will be able to maintain the current dividend and no cuts will be made.

Source: The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.

Summary

ARI has several external and internal risk factors and the external factors are not in their favor at the moment and with the rate hike in 2022 the difficulties will continue. However, the management is actively working on solutions, they are focusing on the long-term horizon. As an income investor the 10%+ dividend yield is attractive and if the management can maintain the dividend in 2022 with the difficulties lying ahead the long-term potential of ARI could be truly remarkable.

This article was written by

Daniel P. Varga profile picture
727 Followers
Started investing more than 10 years ago. Mainly focusing on Large-Caps and occasional story stock. In addition, I am a regular buyer and analyzer of REITs, mREITS, and asset managers. I also have a dividend-focused portfolio with an investment horizon of 15 to 25 years. Follow me for comparison articles such as AAL vs. LUV or USB vs. C.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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