Apollo Commercial Real Estate Finance, Inc. Q2 FY2022 Earnings Call

Good day. I would like to remind everyone that today’s call and webcast are being recorded. Please note that they are the property of Apollo Commercial Real Estate Finance, Inc. and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our earnings press release. I would also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking statements. Today’s conference call and webcast may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these statements and projections. In addition, we will be discussing certain non-GAAP measures on this call, which management believes are relevant to assessing the Company’s financial performance. These measures are reconciled to GAAP figures in our earnings presentation, which is available in the stockholders section of our website. We do not undertake any obligation to update our forward-looking statements or projections, unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.apollocref.com or call us at 212-515-3200. At this time, I would like to turn the call over to the Company’s Chief Executive Officer, Stuart Rothstein.

Thank you, operator, and good morning, and thank you to those of us joining us today on Apollo Commercial Real Estate Finance, Inc.’s second quarter 2022 earnings call. I am joined today by Anastasia Mironova, our Chief Financial Officer. The first half of the year was the most active in ARI’s history, as our team completed a record $3.1 billion of new loan originations on behalf of the company. The robust pace of deployment enabled ARI to effectively and efficiently deploy capital, including the $530 million of net equity received from approximately $1.2 billion of gross repayment. Importantly, ARI achieved distributable earnings that covered the $0.35 per share quarterly dividend and is well positioned for the remainder of the year. While the broader Apollo CRE debt team remained active in the market, we can now be selective with respect to additional deployment on behalf of ARI, while continuing to produce distributable earnings that support the $0.35 per share quarterly common stock dividends. Also reaffirming prior comments, ARI is in a position to repay the 2022 convertible senior notes that mature in August with available capital and without having to complete any public capital markets transactions. Shifting to the portfolio, ARI’s loan portfolio totaled $8.9 billion at quarter end, a 19% increase over the second quarter of 2021. Credit quality remains stable and as evidenced by the repayments in the quarter, our borrowers continue to achieve business plans and have access to capital to refinance our loans. As a reminder, 98% of the portfolio is comprised of floating rate loans, as illustrated on Page 15 of our financial results. The increase in benchmark rates over the past quarter has had a clear benefit to ARI’s net interest income, and we are well positioned for further increases in benchmark rates. It is also worth noting that over 40% of ARI’s portfolio is comprised of loans on European assets. We continue to be comfortable with ARI’s European credit exposure and as Page 9 of the financial results highlights, ARI has used local market financing and hedging to effectively mitigate any currency risk. With respect to repayment activity year-to-date, 11 loans representing approximately $1 billion were fully repaid, and there was an additional $200 million of partial repayment. Included in the second quarter repayments was one of ARI’s larger New York City office loans, which contributed to ARI’s overall office exposure being reduced to 20%. We continue to make progress with our focus loans. Construction has begun on the Fulton Street multifamily tower in Brooklyn. The project is now known as the Brook, and we are excited about ARI’s partnership with the Witkoff Company to execute the development. Support for the project is evidenced by the fully negotiated construction loan we received from two well-regarded real estate lenders, which is expected to close in the next few weeks. It is also worth noting that the operating performance of the Mayflower Hotel continues to improve. As mentioned on prior calls, we are actively working on selling the hotel and are encouraged by the response from potential investors. Finally, with respect to 111 West 57th Street, unit closings have begun with additional units under contract expected to close in the coming months. The traffic numbers are strong and have been boosted recently by more foreign buyers returning to the market. Interest in the building remains high with several active negotiations currently taking place and the response to the furnished model residences is positive. That being said, there is still work to be done with respect to increasing the pace of sales activity, which we anticipate will pick up in the fall coinciding with the robust marketing campaign and finished amenities. With that, I will turn the call over to Anastasia to review ARI’s financial results for the quarter.

Thank you, Stuart, and good morning, everyone. For the second quarter, we reported another quarter of stable financial results with distributable earnings of $49.5 million or $0.35 per share. GAAP net income available to common stockholders was $67.9 million or $0.48 per share, and diluted net income of $0.44 per share. GAAP book value per share prior to the General CECL Allowance and depreciation increased slightly to $15.19 as compared to $15.01 at the end of the first quarter, primarily attributable to net unrealized gains on our foreign currency and interest hedges. As we have previously highlighted, we take several steps to mitigate our foreign currency risk. Given that 44% of the loans in our portfolio are secured by properties in Europe, we hedge our exposure on a net equity basis for all foreign currency-nominated transactions by entering into forward currency contracts at closing. As we have witnessed during this period of significant fluctuations in foreign currency rates, our hedging strategy has proven effective. Our portfolio remains well positioned for rising interest rates, with 98% of our loans being floating rates. At quarter end, 87% of our U.S. and 100% of our UK floating rate loans were in excess of their respective floors. Therefore, we have begun to see the benefits of the increased rates flow through to our net interest income. An additional increase of 50 basis points in the U.S. and the UK would lead to an incremental $0.04 and $0.03 per share, respectively, of net interest income. As of June 30th, our General CECL Allowance increased slightly quarter-over-quarter due to new loan originations and the more adverse macroeconomic outlook, which was partially offset by the impact of portfolio seasoning. With respect to Specific CECL Allowance, during this quarter, we reversed $10 million of previously recorded allowance against our loan secured with a multifamily development in Brooklyn, known as the Brook. The reversal is primarily driven by additional value creation in the underlying property achieved through development activities performed to date. This reversal in Specific CECL Allowance was partially offset by a $7 million allowance we recorded this quarter against the loan secured by a hotel in Atlanta, Georgia. The hotel has had a slower than anticipated recovery following the onset of the COVID-19 pandemic. The aggregate changes during the quarter resulted in an overall CECL reserve of approximately 2.2% of the amortized cost basis and is relatively flat quarter-over-quarter compared to year-end. With respect to our borrowings, we are in compliance with all covenants and continued to maintain strong liquidity. We ended the quarter with $266 million of total liquidity, which was a combination of cash and undrawn credit capacity on our existing facilities and $1.7 billion of unencumbered loan assets. Our debt to equity ratios at quarter end increased as our portfolio continues to migrate towards predominantly first mortgage loans. And with that, we’d like to open the line for questions. Operator, please go ahead.

One moment for our first question that will come from the line of Doug Harter with Credit Suisse. Please go ahead.

Thanks. Stuart, hoping you could talk a little bit more about your current liquidity, especially in light of the upcoming convert maturities, just kind of how that might impact liquidity balances going forward and what that might mean for future loan growth?

Yes, I think it’s a good question. Doug, look, I think even with paying off the convert, I think we’re still on track at this point to end the quarter with several hundreds of millions of liquidity. For us, as we think about that liquidity and how aggressively we want to put it into new deployment, I think it’s part driven by opportunities that we see in the market, and then I would say it’s also part driven by our evolving view of what we think expected repayments throughout the rest of the year will look like just given what’s going on in the overall market. I think if things play out as expected, I think we are comfortably sitting on several hundreds of millions of deployable liquidity that could support with back leverage somewhere between $750 million to a $1 billion of deployment. As I indicated in my remarks, we’re feeling very comfortable about where we are from an earnings perspective for the rest of the year. So, I think we are going to be selective and try and find opportunities that are really interesting as we think about deploying that capital.

Yes, I guess just more on how you kind of get to that ending the quarter with still a couple of hundred million. Is that sort of tapping into some of the unencumbered assets or kind of using repayments as they come in to kind of…

It’s a combination of both. I think one of the big events is what I referred to in my remarks, which is the construction loan on the development in Brooklyn. What that allows us to do is pull out a fair bit of the capital that we funded into the project to date. That capital will theoretically go back in over time as the development moves along. But it initially puts a fair bit of capital back in our pocket, and then there are some other larger transactions that we’ve created during the year, where we will complete the financing on those and that will give us increased liquidity as well.

Great. Thank you.

Sure.

Thank you. One moment for our next question that will come from the line of Jade Rahmani with KBW. Please go ahead.

Thank you very much. Stuart, as you consider the outlook for commercial real estate for ARI’s portfolio for the transitional lending market in particular. What benchmark in the fixed income market do you think matters most? What should we be focused on? For example, the ten-year treasury has declined meaningfully of late that could suggest a soft landing in terms of where cap rates ultimately settle. Would you agree with that? Or do you believe it’s more reflective of the current risk-off environment and not really signaling anything with respect to commercial real estate? Maybe if you could just provide what you look at and also outline some magnitude of severity or turbulence that you’re expecting.

Yes. Look, I think, first and foremost, at the end of the day, Jade, we spend a lot of time looking more at, broadly speaking, macro data as opposed to just interest rate movements. As we think about what’s going on with the broader economy, are we going to have a soft landing? Are we going to have a hard landing? What’s going on with inflation, etc.? So, as we think about the environment into which we’re lending, we try and use the real-time data that we are getting from the loans that we are long, and what we’re hearing from borrowers, both with respect to those loans that are in the ARI portfolio and those loans that are elsewhere within the broader Apollo Real Estate loan portfolio. We also obviously are getting a fair bit of data from what Apollo does on the real estate equity side of our business. And we’re also getting, beneficially, a fair bit of data broadly speaking from what others of Apollo are doing away from real estate and what they’re seeing in the sectors or industries that they invest in. And then there’s also a fair bit of macroeconomic data produced at Apollo. So that, I would say broadly speaking is how we start to think about where the economy is headed, what are we seeing, and how do we think about deploying new capital? Or what does it mean for our existing portfolio? We don’t ignore interest rate in the sense that it certainly has an impact on how we think about pricing and what others away from the Apollo environment might be thinking. But I would say we come back to data, and I would say as we think about new opportunities and as we think about even just protecting ourselves in the current Apollo portfolio. I would say given my earlier comments about us getting somewhat ahead of things from a deployment perspective, I would say we are certainly approaching new deployment with a more cautious view as to what may happen in the economy. And I think until we see some real evidence of an achievable soft landing, I think we will continue to take that somewhat cautious view in terms of underwriting new business plans or even as we think through asset managing the existing portfolio and the various requests we get from borrowers from time to time.

And in that data that you are tracking in terms of the real-time data from the loan portfolio, as well as the other areas you referenced, are you seeing anything pointing in either direction of soft versus hard landing and specifically with ARI’s credit outlook? How are you feeling about the portfolio? Are there other areas aside from the watchlist assets, including the Atlanta loan that we should be attuned to?

I mean, it’s a broad question and let me try and answer it in various pieces if I can. Obviously if you think about the various either geographies or property types that are important to the ARI portfolio, generally speaking hotels are performing quite well. Putting aside the Atlanta transaction, which just to be clear, the Atlanta hotel is still cash flow positive and covering debt service. So, the definition of challenge can be debated, but take my earlier comments on the Mayflower and then look at our hotel portfolio more broadly. Certainly, we continue to see positive trends throughout the hotel portfolio. I think the office portfolio, obviously I commented earlier on the repayment of one of our major New York City office exposures, which was a refinancing on the back of some very successful leasing activity. Generally speaking to comments I’ve made on prior earnings calls, I would say newly created office space is getting quite a bit of attention, as I think there are many companies still in the mindset that in order to get people back to the office, you need to offer them more modern, highly amenitized office space. That’s a theme we continue to see throughout the portfolio. I would say on the for sale side of things, there continues to be activity; it’s not as broadly speaking. It’s not as robust as it was in 2021, but we’re still seeing transactions close and we’re still seeing units put under contract. I think at some level, all of that activity that I just referenced supports the notion that the economy is still moving along, and it wouldn’t be surprising to see the need for continued rate movements to cool things off a bit. But for now, the watchlist represents those assets that we’re concerned about, and generally speaking, the portfolio beyond that is fairly stable to performing quite well.

Thanks for the comments. Appreciate it.

Sure.

Thank you. One moment for our next question, that will come from the line of Eric Hagen with BTIG. Please go ahead.

Thanks. Good morning. A couple of follow-ups on unsecured. Hey, good morning. Can you guys hear me okay?

Yes, go ahead.

Okay, good. Okay. Thanks. Yes, a couple of follow-ups on the unsecured debt. Can you get more specific around the borrowing rate that you expect to pay from drawing on the unencumbered assets? And is there a level at which you’d be constructive on possibly even issuing here, if spreads continue to tighten? What ahead of the last few weeks?

Yes, look I think it’s fair to say generally speaking that the repo market has moved a little bit away from, in favor of the borrower and more towards in favor of the lender. I think that’s not surprising, as you think about what’s going on in the broader securitization market, the CMBS market, the CRE, CLO market, and things have gotten a little bit more expensive or spreads have widened. Some of that has taken place in the market and or the banks that we borrow from as well. That being said, I’d say we’re still borrowing at rates that work extremely well for us and call that high level at benchmark plus high ones to low twos, depending on the asset and depending on how much leverage we’re using. So, as I think about borrowing at those levels versus what might be available in the broader public capital markets, whether it be the Term Loan B market or the convertible notes market, I would say continuing to use the bank market and maintaining optionality before we really do anything with real duration to it, still seems to be the most cost-effective way to do things right now. And I think, again, being inside the Apollo umbrella, I think we’ve benefited from the efforts of the firm overall, as well as some folks specifically on the real estate team in doing a very effective job of making sure we continue to broaden our group of bank lenders. So, long-winded way of saying, I don’t envision us doing anything in the public capital markets, given what we’re seeing on offer today.

Got it. That’s helpful Stuart. Thank you. And then when you guys think about overall conditions in the U.S. and in Europe and you see the euro weakening versus the dollar, how sensitive do you think the demand is for commercial real estate? Or how sensitive will it develop with respect to that migration with capital?

Are you talking about the demand for assets in Europe, in light of the currency movements?

Exactly. Yes.

Yes. Look, I think sitting here today if you look at the European market, there still seems to be a healthy level of capital looking on the equity side for opportunities. I would say again, no different than what I would say about the U.S. I think there’s a lot of capital available. I think everybody is trying to figure out where the overall economy is headed. I think we’ve said on prior calls and I’d say it today Europe probably feels potentially closer to a recession today than the U.S. does. So both have the ability to achieve it, if things don’t go well. I think people are clearly taking a more measured view of what the next few years look like. I also think lending has pulled back a little bit. So, I think there’s clearly demand for assets, but I think volumes will be down. It will take longer for people to get comfortable and complete transactions. But there’s still an open functioning market and there are still bids at various price levels.

Got you. That’s helpful. Thank you very much.

Sure.

Thank you. One moment for our next question that will come from the line of Steven DeLaney with JMP Securities. Please go ahead.

Good morning, Stuart and Anastasia, and congrats on the progress in Brooklyn and the New York office repayment, great quarter. Repayments in the first half of the year are pretty healthy at $1.2 billion. Could you give us some sense, Stuart, what you expect over the second half of the year relative to that $1.2 billion figure?

Yes, look – I think it’s a fair question. Look, I think if things generally speaking go according to plan and that includes some sort of intended bias on our part. I think you’re potentially looking at another few hundreds of millions of repayments on a net equity basis, which sort of implies $400 million to $500 million of gross repayments if you think about it on a gross level. We know for the stuff that we expect to get repaid in Q3, we feel pretty comfortable about that because we know a fair bit of it is effectively just moving towards closing at this point. As we move further out, obviously there’s a little bit more risk to those things happening, but generally speaking, the market is functioning. We expect to be pretty close in our estimate of what we think will happen. And I think that sort of implies probably plus or minus $400 million of repayments between now and the end of the year, which will give us a couple of hundreds of millions to deploy should we choose to deploy it.

Okay, great. So the $400 million to $500 million compares to the $1.2 billion figure. They’re both gross figures. Okay, great. Thank you. Stuart, short-term rates are probably, everybody’s worried about the economy longer term, but I think short-term rates are sort of top of mind for the market and 150 now on LIBOR, maybe we’re 350 by the end of the year, how it’s a pretty significant impact of a couple hundred basis points when you’re making a $100 million loan to people. In your front-end underwriting, how much sensitivity stress do you put on the cost of carry? And then to what extent would you require caps or swaps be obtained by your borrowers?

We will always require a cap, or caps. So, 100% of the things we will do will have interest rate hedges and we will typically require someone to hedge for the initial borrowing period, with any extension beyond that requiring an extension of any hedging instrument. So, we’re certainly well protected from that perspective. And then as we think about cost of carry, we’re basically using the capped cost and the forward curve to think about what’s needed inside the deal in order to cover that debt service over the initial period.

Yes. Makes perfect sense. I just wanted to get confirmation because I’d asked the question before and I’ve received answers that weren’t nearly as clear as what you just stated. Thank you.

Maybe I’m getting better at this.

Yes, no question. You’re doing pretty good. Last question from me, Miami, I think we all took note of Citadel’s decision to relocate its headquarters with respect to your Miami property. How far away are you from where the current path of new office development is to support incoming corporate tenants? You’re sort of more mixed-use, is my memory of having walked the property with you, but is it feasible that over the next three to five years, more decisions like Citadel could positively impact your exposure there in Miami?

Yes. Look, I think Citadel aside, and it’s obviously great news for Miami. Look, Miami, I can only describe as a clear post-pandemic winner, right? There’s just demographic shifts, tax implications, more people working remotely or in different locations; there’s just been so much positive news for Miami, and I think Citadel only adds to that. I think we are maintaining full flexibility with respect to what our sites in Miami could become. If you’ve looked at or were part of the various discussions over the last six months, certainly some type of boutique office is possible, but there are many other thoughts as well. I think the net-net of all of that is that I would say the incoming dialogue to us concerning the sites in Miami continues to increase and more positively, I would say that over the next three to six months, we should be in a position to have a much clearer picture about what the resolution for us will be on those sites.

When you own a piece of property, it’s nice when the phone rings, isn’t it?

Yes, incoming calls are a good thing…

From an owner’s rep or something. Yes.

So, I think there’s, I don’t want to overpromise by Q3 earnings call, but I think between the next two earnings calls, there’ll be definitely some commentary from us on what the path forward is on Miami.

Well, thanks for the color. Stay well and all the best in the second half.

Thanks, Steve. You’re welcome.

Thank you all for participating in today’s question-and-answer session. I would now like to turn the call back over to Stuart Rothstein for any closing remarks.

Thank you, operator. And obviously thanks to everybody who participated this morning.

Ladies and gentlemen, thank you for participating in today’s conference. You may now disconnect.