Earnings Call Transcript - ARI Q2 2021

Operator, Operator

Good day ladies and gentlemen, and thank you for standing by. Welcome to the Second Quarter 2021 Apollo Commercial Real Estate Finance Earning Conference Call. I'd 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, Incorporated, 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 filing with the SEC for important factors that could cause actual results to differ materially from these statements and projections.

Stuart Rothstein, CEO

Thank you, operator, and good morning and thank you to those joining us on the Apollo Commercial Real Estate Finance Second Quarter 2021 Earnings Call. Joining me this morning as usual is Jai Agarwal, our CFO. The second quarter was a busy and productive one for ARI resulting in strong earnings and a continued well-covered dividend. The company originated five first mortgage loans totaling $825 million bringing year-to-date total originations to $1.4 billion. More importantly, the commercial real estate transaction market remains robust with Real Capital Analytics reporting a 167% increase in second quarter volume versus last year. For ARI, we continue to see a high volume of interesting opportunities as our pipeline continues to build. The diversity of the transactions closed to-date once again demonstrates the depth and talents of our origination team and highlights the benefits Apollo's platform brings to ARI. Notably, the transactions secured by the German portfolio of properties and the U.S. portfolio of parking facilities were won due to our team's ability to seek for the entire loan and to be thoughtful, flexible, and efficient in underwriting and structuring. Our European lending platform continues to fire on all cylinders winning many transactions that would otherwise have gone to banks. Year-to-date approximately 70% of our transactions completed were loans secured by properties throughout Europe. As our platform in Europe grows and continues to expand its market presence, we have established a reputation as a reliable innovative capital provider. Our ability to provide borrowers with a one-stop shop for large financings, as well as our responsiveness and creativity around structuring has allowed us to compete very effectively in Europe. With respect to loan repayments, ARI continued to benefit from improving real estate fundamentals and the robust level of liquidity in the real estate capital markets. Three loans totaling approximately $260 million were repaid during the quarter, including one hospitality loan and two subordinate residential for sale loans, one of which was a large New York City project and the other was for a condominium development in Los Angeles.

Jai Agarwal, CFO

Thank you, Stuart. For the second quarter, we reported strong financial results with distributable earnings prior to realized loss and impairments of $59 million or $0.41 per share. GAAP net income available to common stockholders was $64 million or $0.42 per share. As of June 30th, our general CECL reserve remained relatively unchanged quarter-over-quarter. With respect to this specific CECL reserve, we reversed $20 million against our Fulton Street loan as we continue to make progress in readying the site for a multi-family tower development, as well as improvements in the Brooklyn multi-family market. We also foreclosed on a hotel asset in Washington D.C. and recorded an additional $10 million loss bringing our total loss against that asset to $20 million. This is now reflected as a realized loss in our financial statements. GAAP book value per share prior to depreciation and general CECL reserves increased to $15.48 as compared to $15.35 at the end of the first quarter. The loan portfolio at quarter end was $7.5 billion, a 16% increase since the end of 2020. The portfolio had a weighted average unlevered yield of 5.5% in a remaining fully extended term of just under three years. Approximately 89% of our floating rates U.S. loans have LIBOR floors that are in-the-money today, with a weighted average floor of 1.32%. In addition to the five loans originated this quarter, we made $246 million of add-on funding for previously closed loans. With respect to our borrowings, we are in compliance with all covenants and continue to maintain strong liquidity.

Operator, Operator

Our first question or comment comes from the line of Doug Harter from Credit Suisse. Your line is open.

Doug Harter, Analyst

Thanks. You showed in your slide deck that the yield on new loans was just under 6%. Could you compare that to what the yield of the senior loans that are repaying are?

Stuart Rothstein, CEO

Yes, Doug. Look, I think at a high level you're probably looking at a comparable basis as you think about risk and asset type or whatever. You're probably 50 to 100 basis points tighter on the new loans versus the old loans. Obviously, there are some differences in LIBOR floors as well. But as we look at sort of what's in the portfolio now and what we expect to repay. That's the rough range.

Doug Harter, Analyst

Great. And then, I guess shifting to the capital structure. How are you thinking about unsecured going forward? And then with $2 billion unencumbered today, what is your outlook for leaving assets unencumbered? How much of that $2 billion would be eligible to use to support future loan growth?

Stuart Rothstein, CEO

Yes. It's a great question. So, if you look at the unencumbered assets in general, it's roughly about 60% mortgages that are potentially financiable and about 40% to 45% mezzanine loans, which, as you know, we've historically had no interest in putting asset-specific financing on. Though, I think in tough times, the full $2 billion plus is available to use for leverage if we need to. But as we look at the capital structure going forward, I think we've now accessed the convertible notes market, the term loan market, and the traditional bond market. So I think we're quite happy to have a presence in all of the so-called non-asset specific leverage markets available to us. I would say, there's no plans to do anything further in those markets in the near term. I think we will use both available liquidity, as well as selective leverage against some of the unencumbered pool and anticipated repayments as well to continue to stay active on the investing side. And then as we look further out into the future, we will continue to be a strategic and opportunistic user of unencumbered leverage where we can find it, or a non-asset specific leverage where we can find it. I think the capital structure will continue to be a mix of both corporate-type leverage. But we will also continue to use some measure of leverage against a number of our first mortgage investments. But I think we like where we are today in terms of the flexibility that maintaining a large pool of unencumbered assets offers us as we think about both defensive as well as offensive measures looking into the future.

Doug Harter, Analyst

Thank you, Stuart.

Stuart Rothstein, CEO

Sure.

Operator, Operator

Thank you. Our next question or comment comes from the line of Stephen Laws from Raymond James. Your line is open.

Stephen Laws, Analyst

Hi, good morning.

Stuart Rothstein, CEO

Good morning, Steve.

Stephen Laws, Analyst

Good. I hope you are all doing well. Stuart and Jai, could you discuss the REO? If I have the numbers correct, it represents one-fourth of revenue, with $2 million in expenses and $0.5 million in depreciation and amortization. How many quarters and how many days does that cover in the quarter? Additionally, how should we consider the full quarter impact of those line items moving forward?

Stuart Rothstein, CEO

Yes. Jai, why don't you give the technical answer and then I'll give more perspective on the longer-term view of the REA?

Jai Agarwal, CFO

Sure, yes. So that's probably for about six to seven weeks of operations. And then Stuart can give the longer-term view.

Stuart Rothstein, CEO

Yes. I think Stephen, if you think about the asset that we took ownership of, which is a hotel in D.C. that we've talked about before. I think D.C. was slow to open up. It is clearly starting to open up just anecdotally this past weekend. The hotel was well north of 60% in terms of occupancy. So it's moving in the right direction. And as I think as you start to think about forecasting out, in the future, I think we're probably continuing to run slightly negative for Q3. But as we move towards the end of the year, we expect, as long as D.C. stays open, which I know is a big concern given the world we live in right now. But we're definitely moving towards cash flow positive, which is a mix of both better revenue performance due to occupancy and people coming back, but also I think appropriate changes made on managing the cost side as well.

Stephen Laws, Analyst

Great. And then, I wanted to touch on unfunded commitments. Looking at your deck on page 11, it looks like about 70% of your unfunded commitments. So that loan 52, a mixed-use London construction loan originated just before COVID. Can you maybe talk about that small outstanding loan today, but a big unfunded commitment number? So can you maybe talk about that loan and the drawdown expectations of that unfunded commitment?

Stuart Rothstein, CEO

Yes. Look, at a high level the loan is performing exactly as we expected it to perform at this point. We knew it was going to be a long process. A lot needed to happen both in terms of work at the asset, as well as funding of additional equity and subordinate capital before our funding commitment was really going to ramp up. I think you will start to see a ramp of our fundings somewhat later on this year, but in reality, much more pronounced through next year as construction starts in earnest. It is a mixed-use project both for sale residential and some retail. The response to the asset itself has been quite positive. I think we've mentioned before, it’s a commitment where there is clearly a strong bid from those in the market to take a piece of our commitment if we decided to offer up a piece of the commitment. I think that will be a future decision for us based on both our thoughts on our liquidity, obviously thoughts on maximum exposure that we want to any one transaction in our portfolio. And then also the performance of the asset as it moves through construction and people start to indicate early interest in what will be available either on a lease or a for sale basis in terms of what’s being built.

Stephen Laws, Analyst

Great. Appreciate the color there. And thanks for taking my questions this morning.

Stuart Rothstein, CEO

Sure.

Operator, Operator

Thank you. Our next question or comment comes from the line of Jade Rahmani from KBW. Your line is open.

Jade Rahmani, Analyst

Thank you very much. Including credit items, do you view distributable EPS currently as elevated? And should we be thinking about modeling some modest diminution in coming quarters? Or do you believe based on the increased yield on new originations and the pipeline that it's likely to remain at similar levels going forward?

Stuart Rothstein, CEO

Yes, that's a good question, Jai. If you look at what has been recently repaid in the portfolio, it includes some higher yielding mezzanine opportunities that may be challenging to replace in today's market. Additionally, regarding my comments on part of the capital structure for 111 West 57th Street and considering our historical earnings there, I would say that Q2 appears somewhat elevated compared to what I perceive as potential moving forward. However, given our current origination activity, our confidence in the levered return on equity for these new investments, along with various positive and negative factors as we navigate extending loans or restructuring deals, my overall assessment is that we remain quite confident in our ability to continue earning and covering the dividend at a healthy level in the future.

Jade Rahmani, Analyst

Thanks. And based on where things stand today, I guess, year to-date is taxable income running ahead of the dividend, in line with the dividend, or perhaps below the dividend?

Stuart Rothstein, CEO

I'll let Jai answer that question.

Jai Agarwal, CFO

Yes, we generally assess taxable income on an annual basis due to the presence of episodic and lump sum items. We have several considerations regarding taxes, especially if we aim to adjust the dividend. However, we can talk about taxable income in more detail in January for the entire year.

Stuart Rothstein, CEO

Said differently, Jade, I would say the dividend level that we set is based on what we think operating earnings and covering that dividend will be. I'd call it $0.35 a quarter and don't expect the tax situation to impact that one way or the other.

Jade Rahmani, Analyst

Okay. And you don't expect, I assume, something similar to require a special dividend payment?

Stuart Rothstein, CEO

No.

Jai Agarwal, CFO

No. Not at this time.

Jade Rahmani, Analyst

Turning to credit, we've seen the trend of a lot of reserve releases. Do you anticipate that to continue? Or have there been any developments whether it be portfolio specific or macro related such as delayed reopening to cause that trend to slow or perhaps be on pause for the next two quarters?

Stuart Rothstein, CEO

Look, I think what we did on Fulton Street this quarter was probably the one that was most ready for that sort of what you refer to as a reserve release. I think we were intentionally maybe a little slow in getting that done. Given the strength of the market and the progress we're making on readying the site for development, it felt like the right thing to do. I would say, as I look at our high focused assets at this point in time, I wouldn't be expecting anything additional from us on that front going forward.

Jade Rahmani, Analyst

Thanks. And just lastly on Liberty Center, could you give an update on what's going on there?

Stuart Rothstein, CEO

Yes. Look, I think as I've mentioned previously, the challenge or the asset management challenge on Liberty Center is multi-pronged. One is to increase retail occupancy with more of a focus on local and regional tenants as opposed to national tenants. I would say we're making good progress on that front. If things that we expect come to fruition, it will allow us to continue to hang in the low 80% occupancy level. The two other initiatives, which are more about really getting this thing to a finish line that makes sense, are to continue to convert some of the existing retail square footage to alternative use, which in our minds today is more of an office type use. We've signed some office tenants for discrete spaces that lend themselves to that type of use. The bigger project for us is a slightly larger reconfiguration of how the asset lays out to allow us to meaningfully shift some square footage to office use, blending well with the retail. We've had good conversations with prospective tenants and the local planning commissions and boards, so we're making progress. There's a new multi-family project that will be built around the site, which is great news. We're working with the planning commissions to think about ways to use some of our excess parking or surface area to convert those into potential multi-family development sites, which we think would create more density for the site. The partners we've got working with on the site are doing a great job in terms of creating the environment. Foot traffic is back up again, which is great, but still, there's a fair bit of asset management work to be done on our side.

Jade Rahmani, Analyst

Thanks. Appreciate the update.

Stuart Rothstein, CEO

Sure.

Operator, Operator

Thank you. Our next question or comment comes from the line of Rick Shane from JPMorgan. Your line is open.

Rick Shane, Analyst

Hey, guys. Thanks for taking my questions this morning. Stuart, you made an interesting observation related to dividend policy in the $0.35. And obviously, the world's changed a great deal since you set the $0.35 dividend policy last year. I realize the credit environment's likely better, but the interest rate environment is arguably more challenging with how long rates have been at such low levels. I'm curious how you think about the dividend policy now? And with what's in front of you, how challenging that could be?

Stuart Rothstein, CEO

It's a great question. As you know, because I think I've said it to this group collectively many times before, we try and take a modestly long-term view on the dividend. From an investor's perspective, it’s much easier to value what appears to be a somewhat stabilized quarterly dividend as opposed to something that is bouncing around from time to time. It's a similar dialogue we have with the board of ARI, who's ultimately responsible for setting the dividend. I think we've always tried to manage through any quarterly ups or downs relative to the dividend level. When we set the dividend level down last year, which was really right at the start of the pandemic during peak disruption in the market, and with a lot of uncertainty. We were trying to create a level where we looked out over four to eight quarters carrying excess liquidity, expecting there would be some downside in cash flows and other unforeseen externalities. Did we think it was a level we could continue to cover based on various scenarios on the portfolio? That's clearly proven to be the case. I think we've comfortably covered the dividend for the last four or five quarters. Given what we've achieved in the early part of this year, we certainly have set ourselves up nicely to continue at that level on a go-forward basis absent any unforeseen circumstances. The challenge and the exercise we're going through right now, which I think is implied in your question is that we think there’s likely a more steady state experience on the repayment side. We know where we’ve been originating in terms of levered ROEs and where we can continue to deploy capital. As some stuff rolls off, it is important to understand what the model looks like moving forward. I don’t anticipate any changes to where we've settled in from a quarterly perspective. We’ll continue to have those conversations with the board quarterly and refine our model as we move through this year and into next year. But sitting here today, yes, it’s getting more challenging but we're also seeing benefits from the way we think about leveraging and financing our business. So, net-net, still feel okay in terms of where we are. Though personally, I don't love paying an 8.5% to 9% dividend, which is 800 basis points north of the ten-year yield, but it seems like a fair bit of excess return. Given what’s available to us, we can earn it right now.

Rick Shane, Analyst

Terrific. I appreciate the thoughtfulness of that answer. It highlights the resilience of the model if you think back to where we were 15 months ago and how differently the world has evolved. The fact that the dividend is sustainable and covered really demonstrates that resilience.

Stuart Rothstein, CEO

Yes. Thanks, Rich. Look, I've taken a little bit over the last four months and I don't think this is unique to us. I think we were all running throughout this space with a fair bit of excess liquidity, which is obviously unproductive capital at the end of the day. As we start focusing on a more realistic corporate finance strategy even with somewhat tighter returns, everybody's models end up being fairly resilient. We'll see where things go in the future given the incredible amount of capital searching for any type of yield, which continues to make the market highly competitive.

Rick Shane, Analyst

Got it. Okay. Thank you very much.

Stuart Rothstein, CEO

Sure.

Operator, Operator

Thank you. Our next question or comment comes from the line of Tim Hayes from BTIG. Your line is open.

Tim Hayes, Analyst

Hey. Good morning, Stuart. Thanks for all the insight this morning on the troubled assets and focus assets rather. But one more on just the credit side. Were there any notable upgrades or downgrades this quarter? I was looking at the Q and I think maybe I saw one loan might have been downgraded to a four this quarter? I don't know if that's correct. But if you can touch on that or maybe a question for Jai?

Stuart Rothstein, CEO

No. It was only the one that we moved. We moved a piece of a loan to a four which I referenced in the script. It’s also in the subsequent events note in the 10-Q as well. It's a portion of the 111 West 57th loan, which has experienced both self-inflicted, COVID-inflicted, and weather-inflicted construction delays. I think it is clearly on track to be completed. We're excited to get it done. We are focused on getting it done in what appears to be a fairly attractive sales market right now. But we need to achieve more progress on the asset in order to encourage people to make complete sales. But that's the only change for the quarter.

Tim Hayes, Analyst

Okay. Got it. I guess I thought that asset or that loan had already been a four. So thanks for clarifying. And then just on the pipeline, I know you gave some stats about quarter-to-date investment activity and repayments. But can you size the pipeline for us and provide context with repayments, which I know can be difficult to predict? It sounds like you're seeing a normalization in repayment activity. So, just trying to get a feel for your expectations of portfolio growth in the back half of the year as repayment activity picks up a bit?

Stuart Rothstein, CEO

Yes. There are a few points to consider. First, as we've mentioned over the past few quarters, there isn't much for us to engage in currently within the discrete mezzanine loan opportunities. As unencumbered mezzanine loans are repaid and we reinvest that capital into leveraged senior loans, our overall portfolio will naturally increase, which we expect to benefit from in terms of size. Additionally, we are starting to return to a normal rate of repayments. Historically, we originate loans with an average duration of about three years. Due to our practice of extending loans to keep them, we typically see about 20% to 25% of our portfolio paid off each year, and we believe this trend will continue. We are very confident in our ability to reinvest that capital for the remainder of this year. However, we may see a slight decrease in liquidity numbers as mentioned. In summary, we anticipate a modest increase in our portfolio, but not significantly, as we remain in the $7.5 billion to $8 billion range, ensuring we use our equity capital efficiently.

Tim Hayes, Analyst

Got it. That's very helpful. And then just touching on what's in the pipeline right now. Is it pretty consistent with what you'd seen or what's come in over the past couple of quarters? I know you're doing more in Europe. So do you expect those levered returns to be a bit higher there given that market trends tend to lag the U.S.? How do the structures look regarding those types of assets versus what you're observing? I know, it’s kind of a broad question. But just trying to understand the trends in new loan structures and yields versus the portfolio today?

Stuart Rothstein, CEO

Spreads are slightly tighter today compared to what we have in the current portfolio, which seems to reflect the overall interest rate environment. However, I feel that the situation is more stable than anything else. Looking at what we have closed so far this year, it serves as a good indicator of what is currently in our pipeline.

Tim Hayes, Analyst

Okay, great. Thanks for taking my questions.

Stuart Rothstein, CEO

Sure.

Operator, Operator

Thank you. At this time, I'd like to turn the conference back over to Mr. Rothstein for any closing remarks.

Stuart Rothstein, CEO

I'll say, our greatest thanks as always to all that participated in the call this morning. We'll talk to you in a few months. Thanks.

Operator, Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.