Apollo Commercial Real Estate Finance, Inc. Q1 FY2023 Earnings Call

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'd 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'd 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 on the Apollo Commercial Real Estate Finance First Quarter 2023 Earnings Call. As usual, I’m joined today by Scott Weiner, our Chief Investment Officer; and Anastasia Mironova, our Chief Financial Officer. Despite the steady stream of negative headlines concerning commercial real estate, ARI's predominantly senior floating rate loan portfolio produced another quarter of distributable earnings comfortably in excess of the common stock dividend with generally stable credit performance across the portfolio. ARI continues to benefit from higher base rates as 99% of the $8.5 billion portfolio consists of floating rate loans, which has resulted in a 360 basis point increase in weighted average yield on the portfolio over the past 12 months. Higher base rates combined with ARI's robust pace of loan origination in 2021 and the first half of 2022 has put ARI in a position to take a conservative approach to additional capital deployment while still comfortably covering the quarterly dividend to our stockholders. Before I get into more details on ARI's quarterly performance, I want to take a minute to discuss the current market environment. Throughout the first quarter, interest rates have remained elevated and uncertainty around both the trajectory of the economy and future Fed action has persisted. As a result, overall real estate transaction activity was limited. The regional banking crisis only exacerbated market fears with respect to commercial real estate liquidity, availability of financing and asset values. While there will be pockets of distress, particularly in certain sub-sectors of the office market, and it will take time for there to be clarity on the trough and then ultimate recovery of real estate values through this cycle, we believe the CRE market is much better positioned today than it was leading up to the GFC. There is far less leverage in the overall commercial real estate financing ecosystem than there was in 2007. Since 2009, leverage levels generally have remained within the 60% to 70% loan to value range and key market participants. Notably, the large money center banks are much better capitalized. In addition, while still relevant, the overall size and the relative market share of the securitization market have declined, and a larger share of real estate financing has been provided by balance sheet lenders. There is also a record level of dry powder in a variety of real estate equity and credit vehicles that views the current market opportunistically and that dry powder will ultimately be deployed. Lastly, two quick points to note. First, apart from office assets, underlying operating performance for commercial real estate generally remains positive. While the rate of occupancy or net cash flow increase may be slowing, rents continue to trend higher and occupancy levels remain stable. Also, the combination of elevated inflation and tighter financing markets clearly is impacting the supply of new real estate product, which over time should benefit both the performance and value of in-place assets. With that somewhat lengthy backdrop in mind, we continue to take a cautious approach to capital deployment on behalf of ARI and are focused on increasing liquidity through expanding existing financing relationships, putting new facilities in place, and selectively selling loans. As I previously mentioned, higher floating rate base rates position ARI to comfortably cover its quarterly dividend while building more financial flexibility into the balance sheet. During the quarter, ARI finalized a new $300 million asset-backed facility with Banco Santander as well as a $170 million revolving credit facility led by Bank of America. Despite elevated attention to the pullback in real estate lending by regional banks, ARI's key secured lending counterparties remain open for business and are continuing to provide additional financing for ARI's assets. These financial institutions have benefited from the inflow of deposits over the last month and remain committed to commercial real estate lending. Furthermore, ARI has not had any margin calls or requests for deleveraging from any of its counterparties since the failure of Silicon Valley Bank. Another avenue for both generating liquidity and reducing certain exposures for ARI has been to opportunistically sell loans. During the quarter, ARI sold three loans and a portion of another loan, all secured by European properties with aggregate commitments of approximately $237 million, $141 million of which was previously funded to another Apollo managed entity at 99% of par. In addition to reducing ARI's European exposure, these sales also reduced future funding obligations of approximately $100 million. Shifting to the portfolio, ARI remains focused on proactive asset management and working with borrowers on paydowns and extensions where appropriate. As a reminder, ARI's borrowers are generally comprised of sophisticated, well-capitalized real estate operators who typically have significant equity invested in the underlying properties. ARI had several office loans either partially or fully repay during the quarter, and overall office exposure stood at only 18% of the loan portfolio at quarter-end. More than half of ARI's current loan exposure is in Europe, where there are higher rates of office occupancy and where work-from-home is having less of an impact on office usage. The two largest U.S. office loans in the portfolio have capital subordinate to ARI, and in the case of the Long Island City office loan, ARI received a partial paydown from the subordinate capital provider during the quarter in exchange for an extension. With respect to the balance of ARI's near-term maturities, we are in dialogue with all borrowers and expect full or partial repayment on these loans. Many of the loans coming due this year are secured by hotel assets that have performed their underwritten expectations. ARI recently received full repayment on one such hotel totaling $60 million. Let me also clarify something I just said, which is, in any instance where we expect to get a partial paydown, we expect it to be a negotiated transaction where someone is partially paying us down and further committing to the asset in exchange for additional time on their loan. As we look ahead to the remainder of 2023, ARI is well-positioned on multiple fronts. The portfolio continues to distribute stable distributable earnings even while maintaining excess liquidity on the balance sheet. While ARI's transaction volume is expected to slow this year, Apollo remains active in the commercial real estate lending market on behalf of other managed capital, providing ARI insight into market transaction activity and pricing. Continued proactive steps have been taken to strengthen the balance sheet and diversify funding sources and ARI's only near-term corporate maturity is the $223 million of convertible notes coming due during the fourth quarter of this year, which we have already indicated we are prepared to pay off in cash as part of our overall forecast model for the year. Before I turn the call over to Anastasia, it is worth highlighting that at ARI's current quarterly dividend run rate of $0.35 per share, the company is paying common stockholders a 15% plus annualized dividend yield coming off a quarter in which ARI earned $0.51 per share while trading at approximately 60% of book value with earnings supported by a portfolio consisting of 99% floating rate predominantly senior loans. 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. ARI produced strong financial results in Q1 with distributable earnings prior to net realized loss on investments and realized gain on extinguishment of debt of $74 million or $0.51 per share. GAAP net income available to common stockholders was $46 million or $0.32 per diluted share of common stock. The drivers for the delta that were net income and distributable earnings prior to net realized loss on investments and realized gain on extinguishment of debt includes Fed realized events, the increase in our general CECL reserve, equity-based compensation expense, unrealized loss on the interest rate cap, and depreciation on real estate owned, all of which represent add backs for distributable earnings and each contributed about $0.03 per share. It is worth noting that depreciation expense for this quarter includes catch-up depreciation on our DC hotel for the period in which the hotel was classified as real estate owned held for sale up to the point when it was requested back to real estate owned held for investment. Additionally, distributable earnings include the forward points benefit from our foreign currency contract. As a reminder, we hedge our exposure to foreign currency risk on a net equity basis by entering into forward currency contracts for all foreign currency nominated transactions at closing. Forward point impact during the quarter represented $5.6 million or an additional $0.04 per share benefit for our distributable earnings. Outside of the $0.02 per share of forward points associated with the widening of the hedges related to the European loan sales that Stuart discussed, there were no one-time events included in our distributable earnings this quarter. However, I want to highlight that ARI currently has an interest rate cap in place for our 2026 term loan B, which is set to expire in the second quarter of this year. The cap had flat-lined the rate of the term loan B at 3.5%, fixing the base rate at three quarters of a percent. Upon expiration in June of this year, it is anticipated that ARI's interest expense will increase by approximately $20 million on an annualized basis based on the forward curves through the end of the year. Even with the expiration of the cap, ARI will still comfortably cover the common stock dividend this year. Portfolio credit was stable this quarter with no additional asset-specific CECL reserve taken. ARI recognized a $4.8 million loss in connection with the foreclosure of the loan secured by a hotel asset located in Atlanta, Georgia. The hotel is now carried on our balance sheet as real estate owned at a basis of $75 million. We currently are exploring several options for the hotel, including a potential sale. I would also like to point out that our two hotel properties, which are now both classified as real estate owned held for investment, are projected to generate meaningful positive cash flow for the remainder of the year, which would further benefit our distributable earnings. During the quarter, there was an increase in the general CECL allowance of $4.4 million, bringing it to 42 basis points of the loan portfolio's amortized cost basis as of March 31. The increase is attributable to a more conservative macroeconomic outlook, partially offset by the impact of portfolio seasoning as well as loan prepayments and sales. ARI's book value per share, excluding general CECL reserves and depreciation, was $15.72 at quarter-end, an increase of about 5% compared to March 31, 2022. Book value continues to benefit from the company's earnings in excess of the common dividend. With respect to our borrowings, ARI is in compliance with all covenants and continues to maintain strong liquidity bolstered both by proceeds generated from the loan sales as well as the new facilities Stuart previously mentioned. ARI ended the quarter with $357 million of total liquidity, which was a combination of cash and undrawn capacity on existing facilities. ARI's debt equity ratio at quarter-end remained constant compared to the previous quarter-end at 2.8. During the quarter, ARI opportunistically repurchased $7 million of our October 2023 convertible notes at 97% of par, generating a return on equity of about 11%. And with that, I would like to open the line for questions. Operator, please go ahead.

Thank you. Our first question comes from Sarah Barcomb with BTIG. You may proceed.

Hi, everyone. Thanks for taking the question. So just taking a look at the watchlist. We have several of those maturing over the next few months. Was hoping you could give an update on what it would take for us to see specific reserves there next quarter, and how those sponsors have progressed on their business plans as we approach the maturity dates specifically the retail asset in Ohio and the recently added Chicago office asset as well as the hotel in Vegas? Any specific updates there you can speak to?

Yeah. I'll probably take them in reverse order, Sarah. So the retail asset in Las Vegas where we've got a $20 million position outstanding, the asset is actually in the market to be refinanced at this point in time. As I think you've heard me and others on their earnings calls say, hospitality is performing quite well today. We've spoken to both the borrower as well as received a fair bit of information from the brokerage firm handling the refinancing and sitting here today, the expectation is that we'll be paid off with a refinancing. With respect to the Chicago office building, the asset is approximately 85% leased today. It's a sort of a mid to high single-digit debt yield on our basis. The sponsor has been feeding the property to date either through cash injections or guarantees. We expect though it's not done yet, that they will continue to support the asset and we'll probably play for time. There is also $20 million of preferred equity in between our loan and the equity holder. So we think between both the sponsorship and the press position, we expect there'll be some sort of negotiated extension of that loan that gets us comfortable with respect to the asset continuing to be supported. And then in Ohio, which is the asset commonly referred to as Liberty Center, the good news is performance continues to improve. The movie theater is doing better, continuing to recover from the pandemic impact on movie theaters. Occupancy is trending up overall. There are a couple of things on the margin in terms of creating more density vis-a-vis a potential additional hotel parcel, as well as additional multi-family density at the asset that we continue to work through the planning process on. So I would say overall the asset is trending positively. We feel very comfortable with where we've got our loan position marked after allowance. And I would say if positive performance continues, there will likely be an extension this year, but would hope to seek some sort of a exit for the asset potentially as early as the early part of next year.

Thank you. I have one more question. This morning, we noted that one equity REIT reduced its dividend, which has been a common topic in calls this quarter. From the perspective of a mortgage REIT, could you discuss how you view the current 15% yields and your position regarding the dividend at these levels? Additionally, how do you approach stock buybacks, and how do you balance that return profile while still maintaining strong dividend coverage? Lastly, could you explain how the dividend yield perspective differs between a mortgage REIT and an equity REIT?

Yeah. That's a great question. And I think your question sort of alludes to the fact that obviously as a mortgage REIT versus an equity REIT, there's a lot less tax benefit that we get most notably from depreciation because, rarely if ever do we own assets that we actually own a couple now. As my colleagues on the phone with me know, it pains me that we're at a 15% dividend yield this year. That being said, as we think about the dividend, I would say we are at a point now just given how much higher floating rates have contributed to earnings. That I would say that dividend at this point is really about making sure we distribute all of our taxable income. And at this point, I would say there's not a lot of wiggle room with taxable income to do anything with the dividend. If anything, if things broke correctly, we might even be faced with the opposite situation where taxable income requires a little bit more from a dividend perspective, though not ready to commit to that yet. I think vis-a-vis capital structure. We have a $170 million share repurchase plan in place. We were active repurchasers of our shares during the pandemic. You heard Anastasia refer to the fact that we did buy back some convertible notes when they got to a price that we thought made sense for us. And we also coming out of our most recent Board meeting, have authority to do some other things in the other public parts of our capital structure to buy back if we think it makes economic sense. And you should certainly interpret that given my comments on building up liquidity within the ARI balance sheet; I would say one of the things we are certainly thinking about discussing and debating is the notion of how much of that liquidity we want to use just for what we perceive to be very attractive ROE investments within our own capital structure versus doing the next marginal loan in the market. So very much top of mind right now.

Thank you.

Sure.

Thank you. Our next question comes from Richard Shane with JP Morgan. You may proceed.

Thanks guys for taking my questions this morning.

Sure.

There seems to be a significant disconnect here regarding your CECL reserves at 42 basis points. Our calculations differ slightly. The market is pricing in a cumulative loss rate of about 10% on a levered basis. What accounts for this difference? Ultimately, this ties back to Sarah's earlier question. If you found an investment where the anticipated loss rate was 45 basis points, yet the market was pricing it at 10 points, and you could achieve a 15% yield on that investment, wouldn’t you jump at the opportunity? This raises the question of why not be even more aggressive with the buyback?

I think it's a great question, Rick. I think a couple of comments on that. I'd say one thing we're always mindful of is our covenants and leverage, which means if we're shrinking the equity side of the book, we need to be mindful of what's happening on the liability side as well because we can't put ourselves in a box vis-a-vis economic flexibility. So it's something we debate often. I think in terms of what we typically trade on a daily basis, there are limitations on how much we could actually buy back. At a moment in time, to be fair. But as I said to fair, we've got the capacity to do it. It's certainly very much on our minds as we think about what to do with our capital. And then there's also a timing component to it. And while I actually think where things are trading across the sector, not just for ARI, doesn't make sense to what I'm seeing in the market. I'm not sure what actually causes that to change. And I would say as a potential buyer of my stock, if I'm going to buy it, I want to make sure I'm an intelligent buyer of it and buy it at the right price. But everything you say is very much a part of how we're thinking about things internally.

Stuart, thank you so much.

Sure.

Thank you. Our next question comes from Jade Rahmani with KBW. You may proceed.

Thank you. Well, I just thought I'd follow up on the last framework, because I look at it a little bit differently. If we look at the historical spread at which the mortgage REITs trade relative to treasuries, it tends to be around 650 to 750 basis points. And then you're adding a little bit of cushion given an uncertainty premium right now. So that would be 11%, 12%, maybe 13% dividend yields. Certainly, if these mortgage REITs issued preferreds, they could be in the 9%, 10% range. So the common stock dividend should be higher. Just extrapolating that versus ROEs in the 9%. You're already at a discount to book value, 85% of book value, 90%. And then the companies are leveraged. And then they also have liquidity needs if they are going to have non-performing loans. So I think the implied losses are more like 4%, which might be extreme considering 65%, 70% LTVs. But do you disagree with any of that? Curious as to your thoughts.

I'm looking at a situation where the book value is 1550, and the stock is trading at 950. This suggests that investors believe there are $6 in losses per share on 145 million shares, along with my CECL reserves. It appears that the market is valuing my stock at $1 billion less than its book value. We can discuss different perspectives, but the math just doesn't add up for me.

Okay. Well, I appreciate that comment. I wanted to ask about 111, West 57 since it is such an outsized position. How are sales pace and pricing trending? I think there's been some decent comps in the market in terms of magnitude of transactions and what the outlook is there. So curious on that specific asset, if you could give any update.

I think pricing is consistent with our expectations when we took our most recent reserve last quarter. We anticipate about $60 million in sales to close in the next month, which will contribute towards reducing both the senior mortgage and the senior most notes on a pro-rata basis. We are definitely seeing an increase in foot traffic. The next four months are crucial as we approach the prime selling season from spring through fall, which will give us more insight into pacing. The early part of the year aligned well with our expectations, but our underwriting assumes activity will ramp up during the prime selling season. We need to see how much of the increased foot traffic translates into sales.

And as to the $60 million of sales closing in the next month or so, when were those contracts signed?

One was signed very recently and one which was a bigger unit was signed last year, and there's just been a lot of work being done to the unit on a customized basis for the owner.

Thanks so much.

Sure.

Thank you. Our next question comes from Steve DeLaney with JMP Securities. You may proceed.

Thanks. Good morning, everyone. Can you hear me?

Yes. Good morning, Steve.

Thank you. The landline is down, so I'm calling from my cell phone, but I'm glad it worked. Stuart, I hear you loud and clear on the 15% dividend yield. I want to mention that I have a couple of well-known sponsored commercial mortgage REITs at 17%. So if that makes you feel better, you're not alone. I think this—go ahead. I'm sorry. I didn't mean to interrupt you.

We're happy for the company. We were just hoping over the year, we all tightened, not all widened together. So I got it.

Absolutely. I believe that the future direction of the Federal Reserve will play a crucial role. Lower interest rates would significantly benefit the group, and there is some optimism for that in 2024. This discussion about capital allocation and the expected return on equity has been quite enlightening. With the current situation of 24 company commercial mortgage REITs, I wonder if this is a moment for reflection for CEOs and Boards regarding our target portfolio profiles. We need to consider the development stages, whether it’s lending or earlier stage heavy transitions versus more stabilized property types. Even if that results in 200 to 300 basis points lower yield, we must also take into account the downside risks. There is considerable debate regarding the potential impact on book value, with many anticipating declines of 25% to 30%. I’m interested in how your team views the current opportunities. If you have additional capital to invest today, which property types do you find most appealing? Is it feasible to pursue lower-risk properties, like industrial or others, that could still provide attractive returns compared to office or condo types? I’m eager to hear your overarching thoughts on investing in the portfolio moving forward. Thank you.

No, that's a great question, and it's a topic we regularly discuss. One thing I would add to the conversation is that what we consider safe today may not be safe tomorrow. For example, hotel assets were seen as very risky during the pandemic but are performing exceptionally well now due to limited supply. Therefore, the concept of what is considered safe at any given moment is something we continually assess. Additionally, the current market reality is that capital is still available. While valuations and pricing have shifted, spreads have actually narrowed in the past three to six months. From our perspective, there isn't really a deal of a lifetime at this moment. However, with higher base rates and current spreads, we can take a more conservative approach to risk. This is less about the type of property and more about the actions taken regarding the asset itself. Regarding your question about development or conversion risks versus more traditional asset classes in perceived better markets, we are definitely considering it from that angle. We're also spending considerable time thinking about ultimate sponsorship, and as we've become more senior in our position, we've generally been satisfied in situations where there’s press equity or sub-debt backing us as we seek to recoup investments or resolve certain assets that haven't met their business plans. This has proven to be very beneficial for our franchise as we navigate these challenges. So while I won't specify any particular asset types, that gives you a sense of how we are approaching our next investment.

Yeah. That's helpful. And you mentioned debt capital is not going away. As painful as it's been, this is obviously not the GFC. And I'm just curious if there's enough blood in the water out there that you're seeing any sovereign wealth or mega money starting to nibble around, not so much on the debt side, but on the actual equity coming in and buying distressed properties. Is there any sign of that happening? Or are we unfortunately not quite cheap enough yet for that?

There is capital, and there is a lot of chatter. I would say we've yet to see any meaningful transaction activity.

Got it. Well, thank you for the comments and all the best.

Thanks Steve.

Thank you. Our next question comes from Stephen Laws with Raymond James. You may proceed.

Hi, good morning.

Morning.

Stuart, actually I want to follow-up on Steve's question and others have asked about buybacks. But I mean, the comment about a lot of peers being at very similar multiples, but I think you're very familiar with and other parts of Apollo probably borrow and do investments with those. Have you ever looked at buying a basket of common stocks of your peers? I mean, it gives you similar exposure valuation yields. It doesn't permanently retire your capital. You don't have to pay a fee to raise it later. It doesn't change your leverage metrics. We saw a couple of mortgage REITs do that in 2009 after the word valuations were in 2008, but it good REIT income, good REIT assets. It might trigger a taxable gain when you sell it, but that'd be a good problem to have. So just curious about your thoughts on possibly buying some of your peers' stock.

It's an interesting question. Looking back at the pandemic experience, even though it didn't involve ARI, there were certainly other areas of Apollo that took advantage of opportunities in the mortgage REIT sector, particularly on the residential side rather than the commercial side. The essence of your question is valid. I would say that when Scott and I are involved in those broader discussions at Apollo, it's less about direct involvement and more about being a resource for potential capital where those types of strategies are more necessary, as opposed to how we see ARI focusing on its core function as a lending entity. Your question is certainly thought-provoking.

Well, great. Maybe we can discuss it further sometime.

Sure.

And then along those lines, when you think about the tailwind of earnings, the dividend coverage, higher rates, strong portfolio performance, some of which is benefiting from money caps or continued and those type things. But you look at the forward curve, rates could move lower quickly before given the repayments before a lot of your capital resets to higher LIBOR floors is embedded in new originations. You guys have been more active than most of your peers with regards to using swaps and caps and things to lock in return. Have you looked at buying your own floors just to put those in place, not a lot of capital may turn over on a 5% LIBOR world and maybe protect spreads as you look out to where the forward curve may be in 18 months?

It's a constant dialogue internally. Obviously, there's a lot of expertise in the firm around various hedging and swap strategies and either myself or Scott is constantly sort of pressing on that notion about how we should be positioning the books. So I haven't asked it yet, but it is very much on the radar screen.

Great. Appreciate the comments this morning, Stuart.

Sure. Thanks for the time.

Thank you. And this concludes the Q&A session. I'd now like to turn the call back over to Mr. Rothstein for any closing remarks.

Thank you all for participating this morning. Obviously, as things have been slow, myself and Hilary, if we could provide perspective or answer questions going forward, always happy to do it. Thanks for the time.

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.