I Was a Buyer of This Outlier and I M up 16% YTD

I Was A Buyer Of This Outlier And I’m Up 16% YTD

Since my last article on Apollo Commercial (ARI), on January 23rd, shares have climbed over 10%, and combined with the double-digit dividend, shares have returned over 20%.

As many readers know, I generally don’t wave the green flag at many REITs yielding double digits, but I had to make an exception with ARI. Here’s how I explained it (back in January):

“I believe that ARI is well-positioned to continue paying a dividend covered from operating earnings…ARI has ample infrastructure in place to scale the loan portfolio to over $3 billion. This should provide adequate cushion for the company to generate steady growth and possibly dividend increases in future years.”

Apollo Was An Exception

The commercial mREIT sector is broken down into two categories: pure balance sheet lender and balance sheet/conduit lender.

A pure balance sheet lender originates or purchases loans for their own balance sheet and holds these loans on their balance sheet (although they may sell participation units in the loans to diversify some of the risks). Blackstone Mortgage Trust (NYSE:BXMT) and Apollo Commercial Real Estate Finance (NYSE:ARI) are examples.

A balance sheet/conduit lender originates and/or purchases loans for its own account (balance sheet) or to be sold into a securitized vehicle such as CMBS (conduit). Ares Commercial Real Estate (NYSE:ACRE), Ladder Capital (NYSE:LADR) and Starwood Property Trust (NYSE:STWD) are examples.

There are differences between these two types as well and risk can be further diversified. Balance sheet lenders originate loans with the intent of holding them on their books. Balance sheet/conduit lenders originate loans for both their own books and to sell into securitized markets such as CMBS.

The risk with balance sheet lenders is relatively straightforward - the risk that the loans don't perform as expected. Balance sheet/conduit lenders have the risk of non-performance as well as the risk that the conduit market experiences a disruption and cannot take as many loans as expected.

The bottom line is that investors in commercial mortgage REITs have multiple options and risk profiles from which to choose. How an investor views the world and the market can be accommodated by the type of mortgage REIT they choose.

ARI primarily originates, invests in, acquires, and manages performing commercial first mortgage loans, subordinate financings, commercial mortgage-backed securities, and other commercial real estate-related debt investments.

The REIT is externally managed and advised by ACREFI Management, LLC, an indirect subsidiary of Apollo Global Management, LLC, a leading global alternative investment manager with a contrarian and value-oriented investment approach in private equity, credit-oriented capital markets, and real estate.

Looking specifically at the Q1-17 investments. ARI remains focused predominantly on floating rate first mortgage loans. At quarter-end, 88% of ARI’s loan portfolio was invested in floating rate loans and the pipeline remains weighted toward LIBOR floaters, which leaves ARI well-position for the anticipated rise in short-term rates.

ARI’s loan portfolio totaled $3.2 billion (as of Q1-17) with a fully levered weighted average underwritten IRR of approximately 14% and a weighted average LTV of 63%.

As seen below, ARI's portfolio consists of first mortgage loans (62%) and subordinate loans (38%):

Around 87% of the portfolio is spread across the US and 13% invested in Europe:

The loans are diversified across sectors: Hotels (16%), Multi-Family (10%), Retail (4%), Healthcare (9%), etc..

ARI has generally avoided financing malls. The collective view of ARI’s team based upon many years of experience is that the outcomes from mall lending and investing can be unpredictable and binary and the company strategically sought to avoid that risk.

As such, ARI’s exposure to traditional retail is a limited to two loans totaling $195 million, one for the retail portion of a recently constructed lifestyle center in Cincinnati, Ohio; and the second, a street-level retail condo at a main in Maine location in South Beach at the base of Lincoln Road, which just closed this past quarter.

At quarter-end, CMBS represented just 5% of ARI’s net equity and the company expects the investment in CMBS will continue to wind down both as bonds repay and it pursues sales.

The four loans that ARI closed during Q1-17 are first mortgages on well-capitalized hotels at an attractive basis with lower loan to value ratios. The weighted average LTV across the loans is sub 60% and 58%. While not critical to ARI’s underwritten thesis, since the election in November, the hospitality industry has seen uptick in performance and expectations, which has benefited the underlying properties ARI financed.

At quarter-end, 88% of ARI’s loan portfolio was invested in floating rate loans and the pipeline remains weighted toward LIBOR floaters, which leaves ARI well-position for the anticipated rise in short-term rates.

A Favorable Backdrop for Commercial Real Estate Lenders

Starwood Property Trust (NYSE:STWD) is a closer peer to ARI. Although larger in size (STWD's market cap is $5 billion), STWD invests in first mortgage loans (56%), subordinate/mezz loans (29%), preferred equity (5%), and other loans (10%).

Remember that first mortgage loans are senior to all debt transactions, so ARI has the riskiest mix of investments (as compared to these three).

As noted, ARI is a commercial mortgage REIT, and the economic backdrop is supported by strong real estate fundamentals. Fueled by job growth and positive consumer sentiment, real estate operating fundamentals have continued to improve. Supply has been limited in most markets and asset classes; pipelines are still subdued.

The pending maturity wall and the CMBS market volatility are creating lending opportunities, as evidenced below:

At the same time, credit quality is stable and revenue growth is steady…

….and new supply is muted…

The current economic climate remains very favorable for ARI’s business model. While recent data indicated commercially real estate transaction volume was down in the first quarter, there is still a healthy level of acquisition refinancing and recapitalization activity, which continues to create a strong pipeline of opportunities for ARI.

The market remains competitive (see KREF article HERE) but given what has been accomplished in ARI (7+ years as a public company) and the strength of Apollo’s real estate credit platform, ARI remains confident in its ability to find investments that meet target investment criteria.

The Latest Earnings Results

For the first quarter of 2017, ARI’s operating earnings were $38.6 million or $0.41 per share compared to $29.8 million or $0.44 per share in 2016.GAAP net income for the same period in 2017 was $37.8 million or $0.41 per share, as compared to $12.8 million or $0.18 per share in 2016.

ARI ended the quarter with a 1.2x debt-to-common equity ratio and during the first quarter ARI upsized its facility with JPMorgan, increasing the borrowing capacity to $1.1 billion and extended the maturity date to March of 2020. At quarter-end, ARI had just under $900 million outstanding on this facility.

Also in April, ARI upsized the Deutsche Bank facility to $450 million, plus its asset-specific financing of £45 million. ARI has significant capacity available under both credit lines. Recently S&P added ARI to the S&P SmallCap 600 Index.

Maintaining a BUY

ARI has maintained a high dividend yield and on the latest earnings call the company said the “Board will meet again in mid-June to discuss the Q2 dividend and we will make an announcement shortly thereafter.”

ARI’s expects to generate earnings of $1.92 in 2017 and the dividend ($1.87) is well-covered. Here’s the 2018 earnings forecast for the commercial mREIT peers:

ARI has one problem loan in the portfolio, a multi-family asset in North Dakota. As you can see below, ARI classified the loan at 100% LTV, and here’s what the company said on the last earnings call,

“It’s effectively a cash flow mortgage at this point for all practical purposes. And I would say, given performance of the asset at this point, it is a low to mid-single-digits return on sort of the recast balance…

In some respects, we are playing for time. It’s an unlevered asset on our behalf. So, we can hold it on balance sheet for as long as we need. I think the asset I would describe as stable, which is somewhere in the mid to high 70s, low 80s from an occupancy perspective, rents have not moved much, I would say anecdotally, the commentary around Williston and the Bakken in general has been somewhat more favorable over the last few months just in terms of rig counts, employment expectations, barrels coming out of the ground.

Beyond what’s physically constructed, there are some incremental both entitled and un-entitled land that serves as collateral as well. And I would say there is regular weekly dialogue amongst us, the borrower as well as the on-site property manager in terms of leasing progress, leasing strategies and also maybe, abilities at some point, call it in the short to mid-term to maybe monetize some of the excess collateral.

But it’s a regular dialogue. We have fully protected all our contractual rights as a lender. But I would say at this point, we still view it as a sort of beneficial to working this out to keeping the borrower engaged and working with us and trying to get to a solution. But to be perfectly candid, this is going to take time.”

The Bottom Line: ARI is performing as I expected, and I suspect the company will boost its dividend in the near future. In regards to KREF entering the commercial mREIT sector, ARI’s CEO, Stuart Rothstein,explained,

“We feel confident in our ability to get capital deployed. We feel confident in our ability to find transactions that make sense. We’ve always expected there would be additional competition in the companies that are hopefully going public tomorrow or in the future are not surprises. And in some respects, arguably having more companies public in the space might actually be a good thing in terms of equity investor focus and coverage of the space and giving investors more reason to track what’s going on in the commercial mortgage REIT public space, which has become a small group of companies and we will probably benefit from having more names in the space.”