Apollo Commercial Real Estate Finance, Inc. Q2 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 second quarter 2023 earnings call. As usual, I am joined today by Chief Investment Officer, Scott Weiner; and Anastasia Mironova, ARI's Chief Financial Officer. ARI had another consistent quarter of distributable earnings prior to net realized losses on investments comfortably above the common stock dividend, driven by higher base rate tailwinds in ARI of $8.3 billion floating rate loan portfolio. Over the past 12 months, the weighted average yield of the company's loan portfolio has increased approximately 350 basis points. Despite ARI's solid performance, the real estate market continues to go through a period of recalibration, highlighted by the prevailing negative sentiment around the asset class. Notwithstanding the sentiment, property level fundamentals across most property types remain stable. However, concerns with respect to refinancing risk and the impact of the potential economic slowdown persist, creating differences of opinion on valuations between buyers, sellers, owners, and lenders. As a result, transaction volumes continue to be muted amidst ongoing price discovery. Within ARI's loan portfolio, there were several positive events that occurred during the quarter. The borrower on ARI's largest office construction loan commitment signed a letter of intent with a global financial institution for a 20-year lease for the entire building significantly de-risking the transaction. As a reminder, only 18% of ARI's portfolio is comprised of loans secured by office properties with approximately 60% secured by properties in Western Europe. Beyond the transaction referenced above, which represents 13% of ARI's office exposure, partial repayments totaling approximately $125 million have been received or are in process across another five office loans, encompassing situations whereby the borrowers are paying down between 15% and 20% of the outstanding loan balance and renewing guarantees for carry costs on future leasing costs in exchange for a short period of extended maturity. Year to date, ARI has received $595 million of full or partial loan repayments and there is an additional $300 million that has or is expected to occur during Q3. Elsewhere in the portfolio, the Mayflower Hotel continues to have strong operating performance with net cash flow up significantly since ARI took ownership and now exceeding pre-pandemic levels. ARI also received a $104 million partial paydown on the loan secured by our portfolio of parking garages in connection with the sale and re-lease of certain collateral. Subsequently, after the quarter-end, ARI received full repayment from the $20 million mezzanine loan secured by the Las Vegas Renaissance Hotel, which had been a risk-rated 4 loan. In general, ARI's borrowers remain engaged on asset management issues and ongoing dialogue is constructive and focused on borrowers injecting additional equity into transactions in exchange for the extension of term. Turning to the Steinway project, this quarter, the decision was made to put all of ARI's loans secured by the asset on non-accrual status. Year to date, through the end of the second quarter unit sales reduced ARI's exposure by approximately $64 million, with a further reduction of $9 million occurring from a unit sale early in the third quarter. There is an additional unit under contract that is expected to close in the third quarter, which will further reduce ARI's exposure by approximately $40 million. While there has been a modest pickup in foot traffic and buyer interest resulting in some active negotiations on a handful of units, the velocity of unit sales remains behind expectations. Shifting to the right side of our balance sheet, ARI continues to maintain robust liquidity and has access to additional capital from the company's various secured financing facilities. ARI's lenders remain actively engaged in the sector with ongoing dialogue around in place or potential new financing. ARI continues to diversify the company's lender base and expand sources of capital having entered into a new secured borrowing facility during the quarter with a new counterparty. Lastly, in the second quarter, ARI repurchased an additional $37 million of the coming-due convertible notes and an additional $10 million post-quarter end, reducing the outstanding balance to $176 million. As we look to the remainder of 2023, ARI is well-positioned with a portfolio that continues to generate stable distributable earnings while maintaining excess liquidity. We continue to see bright spots across the portfolio and importantly, meaningful borrower engagement. 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 another consistent quarter of financial results in Q2 with distributable earnings prior to net realized loss on investments and realized gain on extinguishment of debt of $65.8 million or $0.46 per share. We declared a common stock dividend of $0.35 per share, the level consistently maintained over the course of the last 13 quarters. This translates to a dividend coverage ratio of 131% and the dividend yield of 12.4% as of June 30. GAAP net loss was $86.5 million or $0.62 per diluted share of common stock. ARI's portfolio ended the quarter with an outstanding principal balance of $8.6 billion with a weighted average unlevered yield of 8.6%. During the quarter, ARI funded $131 million of add-on fundings from previously closed loans and received $243 million in loan repayments, including a $60 million full repayment from a loan secured by a hotel in Phoenix, Arizona. During the quarter, there was an increase in the general CECL allowance of $2.1 million, bringing it to 46 basis points of the loan portfolio's amortized cost basis as of June 30. The increase is attributable to a more conservative macroeconomic outlook and changes in the remaining expected terms for some of our loans. This increase was partially offset by the impact of portfolio seasoning, as well as loan prepayments. With respect to the Steinway building, during the quarter, we recorded a $126 million Specific CECL Allowance on the junior mezzanine A loan and downgraded the risk rating to 5. We also increased the previously recorded Specific CECL Allowance on the junior mezzanine B loan by $15.5 million, resulting in a full allowance against disposition. We, therefore, wrote off the junior mezzanine B loan realizing a loss of $82 million, which was beneficial to us from a tax planning perspective. ARI's book value per share excluding general CECL reserves and depreciation was $14.80, representing a 6% decrease from the previous quarter end. With respect to our borrowings, ARI is in compliance with all covenants and continues to maintain strong liquidity. As Stuart mentioned, during the quarter, ARI entered into a new $130 million secured credit facility with a counterparty that is new to us, further expanding our capital sources. ARI ended the quarter with $407 million of total liquidity, which was a combination of cash and undrawn credit capacity on existing facilities. Our debt-to-equity ratio at quarter end was 2.9x and the company had $857 million of unencumbered real estate assets. And with that, we would like to open the line to questions. Operator, please go ahead.

Our next question comes from Sarah Barcomb with BTIG. You may proceed.

Hi, everyone. Just given the reaction that we are seeing in the stock today, I want to touch on the Steinway Tower a bit more. Do you think now that you have ring-fenced all of the loss potential at 111 West 57th and why do you feel that way now versus what you were expecting at Q1 end? Thank you.

Thanks, Sarah. It's Stuart. Look, I think at a high level, and as I've said multiple times on various earnings calls, we are trying as best we can to sort of assess where deals get done both on a price perspective and on a timing perspective. I think based on dialogue we have had with various potential buyers, we were certainly hopeful that there would be more velocity in terms of the number of units that would be signed. I think, at this point, I think we are still reasonably confident in what we are seeing from a pricing perspective. And I think we have certainly dialed back expectations with respect to timing. I think by turning off the accrual of interest on the senior parts of the capital structure, we have certainly eliminated future basis creep over time, which I think puts us in a position to not create any additional pressure from a pricing perspective. I think at this point, there is definitely active dialogue going on, on a handful of units. Foot traffic is up. I think as we look at how we forecast out the current reserve, it seems reasonable to us, based on what the dialogue is today and how we forecast out. I think for everybody's benefit, I think we have said this before in coming up with the reserve from an accounting perspective, there is both a nominal analysis as well as a time value of money analysis. So it does require us to be as accurate as we can from a pricing and timing perspective. But I would say, sitting here today, certainly looking out over coming quarters, based on dialogue and what we have seen, based on the estimate we have done today, we feel confident in the way we have reserved or written off.

One moment for questions. Our next question comes from Jade Rahmani with KBW. You may proceed.

Thank you very much. I guess the first question on 111 would be, how much of the portion that you haven't reserved relates to large units that could be very hard to predict such as remaining penthouses? Because if we just look at average sale prices and price per square feet, it would seem to me that there is potentially the risk of further write-downs. So that would be one aspect of this deal to try to understand.

Yes, no, I appreciate the question, Jade. Obviously, I would say in some respects, there's better foot traffic and more interest at the penthouse level than in the middle of the building, if you just think about the uniqueness of certain units versus other units. But ultimately, it's just dollars and timing. And whether it is regardless of where the units occur in the building, it's just trying to get units sold and chip away at the outstandings. I would say per your question, we certainly took a high level unit by unit perspective of the building. But I would say the analysis does not overemphasize one unit versus the other as we think about timing and pacing.

Are there about 35 units remaining?

There are a little bit less than that, yes.

And then the second question would just be on, the full position now being on non-accrual making some assumptions for yields, I think we estimated an impact annually around $0.30 to $0.32. And then I also do recall, you have an interest rate cap that expired in the second quarter, which you previously said would be an annual earnings impact of around $20 million. So how do we think about all of this and where the dividend stands? Is that going to be a year-end decision for next year? Or do we expect something there imminently? And if you could provide any commentary or parameters to assess that, it would be great.

Yes, I'd be happy to respond. We have three investments that I would categorize as under review.

Operator? Jade, do you mind repeating the question, please? This is Anastasia. Sorry. Looks like we're having some difficulty with technology this morning.

Yes, I understand, Anastasia. To answer your question, the interest rate cap has expired, and therefore it's not reflected in this quarter. We also placed Steinway on non-accrual status after one month. This quarter considers much of the impact you're mentioning. Based on our forecasts, we can comfortably cover the dividend through the end of the year. So, to address your question, I think it would be best for Anastasia, Hilary, and you to discuss your calculations separately. However, we are not experiencing as significant an impact as you might expect.

Our next question comes from Stephen Laws with Raymond James.

Stuart, I know you touched a little bit on the REO assets in your prepared remarks, but kind of wanted to revisit that, specifically the Atlanta Hotel is held for sale, kind of update on timing for that. And then, on the DC hotel, $6 million of 2Q income, no debt on that asset. You do have some debt on the Brooklyn development. Is the DC hotel something you may look to hold or operate mandate or how do you think about moving that into held for sale or looking to exit that asset?

Yes, it's Scott again. I'm not sure if Stuart was able to rejoin. Regarding the Atlanta asset, we took it over, brought in new management, and rebranded it. It was previously a Sheraton and is now under the Wyndham brand. We're pleased with the transition and have received some unsolicited inquiries that we hope will lead to a sale, which is why it has been listed for sale. While nothing is finalized yet, there are active discussions taking place. As for the Mayflower Hotel, as mentioned in the prepared remarks, its performance is actually exceeding pre-COVID levels. We have engaged management to collaborate with Marriott, and the hotel is performing well as we assess the markets. We are in contact with various brokerage firms to stay updated on market trends. The encouraging news is that cash flow is stable, providing us with liquidity since we have no debt on it. We will continue to evaluate the markets, and if we determine that taking action makes sense, we will certainly consider it later this year or early next year. Lastly, the multifamily development in Brooklyn is progressing well, with the foundation being poured. This project is fully funded with third-party debt financing. The multifamily markets in New York City and Brooklyn remain robust, and we want to see it completed.

Great, thanks. And one follow-up to Jade's question. Anastasia, I believe it was mentioned that Steinway was included in Q2 numbers for a month before it went on non-accrual. Do you have the amount in millions that contributed to 2Q net interest income?

Yes. Thank you for this question. So, as you mentioned, we have put Steinway on non-accrual effective May 1st. So, if you translate it into earnings for this quarter, this was about a $0.06 per share net loss in Q2. So on a quarterly basis, it's about $0.10 per share looking forward. But as Scott has previously mentioned, in response to Jade's question, based on our projections taken into account that Steinway, the full stack is now on non-accrual basis and as well as taken into account the interest rate cap, which as Jade mentioned, has terminated early in June. We are still projecting that we will be able to comfortably cover the dividend in Q3 and Q4 for the remainder of the year.

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

Thank you for taking my questions this morning. As we consider the current situation, one issue we are all facing is the timing of realized losses. Can you explain what the triggers were in the second quarter that led to the realized loss?

Sure. Anastasia, do you want to talk about the tax impact? I mean, I think it's two-fold. One is, as we look at and update our model, we don't think there will be a recovery of that junior most mezz, whereas I think Stuart referenced part of the analysis on the other reserve this time. And so there is a discount factor. So we are hopeful that if our estimates of sale prices are correct, our absolute dollar recovery will be higher than the reserve we have taken, just because we had to discount that over a period of time that we think it'll take to sell the units. Whereas on the junior, we don't think we recover that. But as Anastasia mentioned, there is also a tax implication. So Anastasia, do you want to talk about that?

Yes, absolutely. And piggybacking on Stuart's earlier remarks and Scott's remarks, definitely based on where we stand today, we previously had the $66.05 million reserve against the bottom, the junior mezzanine position. It's an $82 million position. So it was us raising the CECL allowance this quarter. That position became fully reserved. It had a 100% Specific CECL Allowance against it. And we deemed it to be unrecoverable as far as the timing that you are highlighting. There was an opportunity for us to take an advantageous tax treatment, which is why we have opted to take the realized loss in the current quarter as opposed to taking it later.

Got it. And so to continue this a little bit further. So you guys have talked about the expectation of dividend coverage through the year. And really there are two earnings metrics. There is distributable earnings including and excluding realized losses. When we look at it on a realized loss basis, you guys are probably about $0.35 year-to-date versus the dividend. So the payout ratio is actually below a 100%. Is the implication then that the dividend for the year based upon that will be characterized partially as a return of capital?

Yes, I think we are in the middle of the year now. So we will have to complete the assessment as we near the end of the year. So I think it is still in the early stages. But I think the bottom-line here is that the dividend will be fully covered based on our earnings projections as of today.

Fully covered on an earnings projection basis for distributable earnings, excluding losses.

Yes. That's correct.

Our next question comes from Doug Harter with Credit Suisse. You may proceed.

Thanks. Can you just talk about your plans and the amount of liquidity you plan to hold once you kind of settle the convert, the remainder of the year?

Yes, I can take that. This is Anastasia. As you can see from the current quarter and the previous quarter, and as we look ahead for the rest of the year, we are focused on maintaining excess liquidity for ARI. As of June 30, our liquidity position indicates we are comfortably paying down the convertible notes due in October. By that date, we have already repurchased some of that debt, which stood at $186 million in outstanding principal. Additionally, we do not have any corporate debt maturities coming up this year or next year, with the next ones not due until 2026. Overall, we are committed to maintaining excess liquidity and you will continue to see us with a significant cash cushion and available capacity on our existing facilities.

And I guess would the unencumbered assets be the kind of the main source to drive extra liquidity or if you needed to create more liquidity or how do you think about the options for creating that extra liquidity?

I think, you can think about it as a combination. We have available capacity on our facilities. We have our revolving credit facility. We have definitely our unencumbered assets. We're also projecting a healthy level of repayment activity in our portfolio. So all of these can be potential sources of our liquidity going forward.

Our next question comes from Steve DeLaney with JMP Securities, a Citizens company.

Look, in the commercial real estate world, obviously, the lenders, finance companies, the top priority has obviously been liquidity and asset management, which you've commented on this morning. I'm just curious, your $8 billion portfolio, you've seen about $400 million of shrinkage for the first six months of the year. I'm just curious to know what the appetite is for new lending. I would think there's some pretty attractive terms out there. So, if you are considering new loans, where would you focus and where do you see the best opportunities?

Scott, do you want to take that?

Yes, we are continuing to build our liquidity and are receiving repayments, resulting in ample liquidity and market activity. We are actively participating in the market every day by making loans. Currently, our focus is on retaining liquidity for ARI, which includes assessing our own capital structure and upcoming funding needs, even as we evaluate new deals. There are appealing opportunities in the hotel sector and other areas where we can achieve attractive spreads. The financing markets are open, and while we have traditionally been a warehouse borrower rather than engaged in the CRE/CLO market, that market is also showing positive signs. We are confident in our business model, and we are comfortably earning dividends while benefiting from liquidity. Unlike in the past, we are now earning a return on our cash, around 5%, which alleviates some previous concerns. If our repayments exceed expectations and we find ourselves with excess cash, we can consider resuming originations, but that is not on the agenda in the immediate future.

Our next question comes from Jade Rahmani with KBW.

I wanted to follow up on a different topic, not related to Steinway. It seems that overall performance has improved across the portfolio. Could you share why there haven't been any stresses in other areas? Are there any specific loans you would like to highlight? It appears that things have gotten better, and performance in Europe seems to remain strong. Do you have any comments on that?

I appreciate the compliment, Jade. Thank you. We've always considered Steinway to be our primary focus. We're pleased with its performance. Notably, one of our four rated loans, including one of our last mezzanine loans, was paid off on a hotel in Las Vegas, along with other repayments in the portfolio. We addressed our issues early on, as we've stated before, specifically with our two hotel problems and the land in Brooklyn. We continue to actively manage and collaborate with borrowers, who, fortunately, are stable and committed to their investments. They have equity in their projects, and we have never engaged in high-leverage lending, which has helped maintain their support. Europe has been a positive area for us, particularly in hospitality, industrial, and the return to office segments. Additionally, we hedged our currency exposure in Europe, mitigating any risk there. Overall, we are satisfied with the portfolio’s performance. We consistently work on it daily and engage with borrowers, which allows us to achieve pay-downs. The London transaction, which will be the bank's new world headquarters, significantly reduces the risk of that transaction. Once that lease is finalized, I anticipate an upgrade in its rating. Currently, we are in a lengthy process for heads of terms and public announcements, but I expect the lease to be signed soon, leading to an upgrade of that loan. Overall, we are seeing continued repayments, and our modeling indicates that we have notices of repayments coming in from various deals, assuring us that cash will be arriving.

Thanks. The table in the 10-Q provides an overview of the loan portfolio. It indicates that the overall yields on the portfolio remain steady at 8.6%, but the subordinate loan piece, which has a balance of $463.6 million, shows a yield of only 2.2%. Is this primarily due to Steinway, or were there other modifications involved?

By the end of this quarter, Steinway will be the only subordinate debt we have, primarily for historical accounting reasons. We hold the first mortgage, which means we own the entire stack. The hotel in Las Vegas had subordinate debt that has been paid off. There is also a piece of CMBS that we expect to be paid off soon. So, it is mainly all about Steinway, which we have placed on non-accrual. Consequently, that line item will continue to decrease.

So the mezzanine on Steinway is yielding or picking at an interest rate of 2.2%?

It's a non-accrual. So you can....

We're not taking any income.

Zero.

Zero.

Okay. So then the yield in this table, what does it actually reflect? What does that mean, 2%? Maybe that's just the performing mezzanine loans that are on accrual and the total balance is accrual and non-accrual. And so that's why the yield is tough.

Yes. You are taking a majority of it at zero and then you have other stuff at 10%, right? So you had $60 million, $70 million at 10% and you had $400 million-plus at zero. So that's the way...

All right. That makes sense. Thanks for clarifying that.

Thank you. I'd now like to turn the call back over to Scott Weiner for any closing remarks.

Thank you, operator, and thank you everyone for joining us today. And to the extent anyone has any more follow-up questions, both Stuart, Anastasia and I are available. And enjoy the rest of the summer. Thank you.

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