Apollo Commercial Real Estate Finance Inc
NYSE:ARI
Earnings Call Analysis
Q4-2023 Analysis
Apollo Commercial Real Estate Finance Inc
Apollo Commercial Real Estate Finance (ARI) entered 2024 reflecting on a similar sentiment as the year before, with widespread concerns about high interest rates and their impact on property valuations, loan maturities, and the viability of office spaces. Despite a drop in real estate transactions due to these worries and market participants' cautious stance, there is a budding confidence in stabilization through anticipated Federal Reserve rate cuts. Nevertheless, uncertainty about asset value remains, creating a mixed outlook for the sector.
ARI's distributable earnings reached $244 million, equivalent to $1.69 per share, providing a healthy dividend coverage ratio of 1.21x. Ending the year with a portfolio valued at $8.4 billion, they saw a substantial yield increase from the past two years. Risk management measures like interest rate caps covered 81% of the portfolio principal, supplemented by other structural protections, keeping ARI's loan portfolio well-hedged against interest rate fluctuations.
In Q4 2023, ARI was active in deploying capital, investing in new loan agreements totaling $536 million with an emphasis on European assets. Fluidly managing liquidity, ARI operated with $278 million in liquidity resources, boasting a robust position to meet upcoming obligations without any corporate debt maturities due until 2026. They ended the quarter with a debt-to-equity ratio at 3.0x, ensuring an appropriately leveraged balance sheet.
ARI shows prudent asset management with long-term lease agreements and recently completed leasing activities in its Long Island City and Manhattan properties, indicating movement in a positive direction. In Long Island City, the attraction of being a cost-effective alternative to Manhattan plays to ARI's advantage, setting up a favorable outlook. In Manhattan, discussions for potential restructuring of a challenging asset indicate proactive measures to safeguard ARI's senior mortgage position.
As interest rates approach a pivotal point, borrowers are adapting their hedging strategies, which is pivotal for ARI's interest coverage. With cap costs dropping, ARI's borrowers have the choice to buy caps at varying levels or build interest reserves as a form of self-insurance, illustrating ARI's tailored approach to risk management across its diverse borrower base.
For instances where interest rate caps are not in place, ARI leverages other forms of credit enhancement like strong sponsorship guarantees, providing additional layers of risk mitigation and capital buffers. This strategic flexibility highlights ARI's capacity to optimize its loan portfolio's credit structure in varying economic scenarios.
ARI's European investments have exhibited robust performance, reflecting its strategic preference and the parallel it draws with the U.S market. This consistent success in Europe reinforces ARI's international diversification and expertise in global real estate finance.
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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, 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 at this time, I'd like to turn the call over to the company's Chief Executive Officer, Stuart Rothstein.
Thank you, operator. Good morning, and thank you to those of you joining us on the Apollo Commercial Real Estate Finance Fourth Quarter 2023 Earnings Call. I'm joined as usual today by Scott Weiner, our Chief Investment Officer; and Anastasia Mironova, our Chief Financial Officer.
In many ways, the start of 2024 feels very much like, where we were at the start of 2023 for the commercial real estate sector. If you recall, entering 2023, there was significant negative sentiment concerning commercial real estate, fueled by concerns over the impact of elevated interest rates on valuations and pending debt maturities uncertainty on the long-term use case for office properties and a lack of consensus with respect to both the path of the economy and the future trajectory of interest rates.
The Fed, continuing to raise rates in the first half of 2023 and the notable volatility in the 10-year treasury rates further added to the concern and uncertainty in the market. In addition, the failure of several notable regional banks, coupled with increased reserves and negative commentary from money center banks regarding their real estate portfolios further added to the generally pessimistic perspective.
While there were some notable transactions throughout 2023, which started the process of revaluing real estate in a higher interest rate environment, but overall transaction volume was significantly lower than recent years as market participants, including owners, lenders, potential buyers and sellers all chose to play for time and remain cautious in the face of an uncertain economic and interest rate environment.
As we enter 2024, there is increasing confidence in the Fed's ability to engineer some type of soft landing and expectations of 100 to 150 bps of Fed rate cuts throughout the year. On the long end, the 10-year is essentially exactly, where it was at the beginning of 2023. And at present, fears of that rate moving higher as it quickly did last year, are muted. However, while there may be more optimism with respect to the economy and rates, the narrative around commercial real estate continues to focus on further asset value degradation.
There is still much to be done to address loan maturities and asset level capital structures in a higher rate environment in addition to the lingering uncertainty over the long-term use case for certain assets. Pivoting away from the value debate, operating performance across much of commercial real estate has remained stable to positive. Notable exceptions include certain office markets as well as pockets of the multifamily sector that have begun to experience declining rent growth in the face of elevated supply.
Over the long term, we expect that property level operating performance will be closely aligned with the broader macroeconomic climate and many property sectors will benefit from a notable decrease in new supply over the last few years.
With respect to ARI, 2023 was a year focused on proactive asset management and maintaining excess liquidity, while expanding and diversifying financing sources. Given the tailwinds from higher base rates, ARI achieved strong distributable earnings, which comfortably covered the dividend and demonstrated the earnings power of the company's floating rate loan portfolio.
During the fourth quarter, ARI strategically pivoted and deployed $536 million into 2 new loan transactions and the upsizing of an existing loan as we identified compelling opportunities to originate loans at attractive pricing with recent valuation, strong credit structures and lower LTVs. All 3 of these loans secured properties in Europe.
Shifting to the portfolio. At year-end, ARI had 50 loans, totaling $8.4 billion. ARI received $1.2 billion in loan repayments and sales during 2023, including $270 million from office loans. Throughout the year, our team remained actively engaged with ARI's borrowers, negotiating and completing paydowns and extensions, where appropriate.
For ARI's focus assets, the 2 REO hotels produced stable cash flow throughout the year, with the Washington, D.C. asset generating NOI from hotel operations above pre-pandemic levels.
With respect to Steinway, we closed on the sale of 1 unit in the fourth quarter, and there are 2 more units under contract. There are also active negotiations on a handful of additional units, however, nothing is done until it is done. Based on recent activity at the building, our views have not changed with respect to the nominal achievable value on sellout. But as a reminder, accounting does require a present value assessment of achievable value. Recent activity was generally consistent with previous estimates, and as such, no additional reserve was recorded during the fourth quarter.
Any future change to the reserve level will be based upon assessment of both the potential nominal value of remaining units as well as the expected timing of realization. Before I turn the call over to Anastasia, let me make a few comments on ARI's quarterly dividend. As a reminder, our quarterly dividend run rate is $0.35 per share, and it has been at that level since we proactively reduced the dividend right at the beginning of the pandemic in 2020.
As I have stated many times previously, the dividend is ultimately dependent on board action, and it is reviewed and discussed and ultimately declared by the Board on a quarterly basis. While it is subject to that Board approval, at present, our current modeling for the future indicates that we remain comfortable with the current dividend level of $0.35 per share. We will obviously review it with the Board on a go-forward basis, but in light of questions that we anticipated, I wanted to provide that context at this time.
With that, I will turn the call over to Anastasia.
Thank you, Stuart, and good morning, everyone. ARI had a strong year of operating results in 2023. Reported distributable earnings of $244 million or $1.69 per share, which resulted in dividend coverage of 1.21x.
GAAP net income available to common stockholders was $46 million or $0.29 per diluted share of common stocks. ARI portfolio ended the year with a carrying value of $8.4 billion, with a weighted average unlevered yield of 8.7%, 110 basis points higher than at the end of 2022, and notably, 380 basis points higher than at the end of 2021.
As Stuart mentioned, during the quarter, we closed $536 million of new commitments across 3 deals. $275 million of these commitments was funded during the quarter. $212 million was funded subsequent to quarter end, and the rest will be funded in the future. We also completed $131 million of add-on fundings from previously closed loans and received $205 million in loan repayments.
As of year-end, approximately 81% of the principal balance of our portfolio was covered by interest rate caps. Important to note that most caps expirations are tied to the initial of final maturity of loans, where a part of the extension conditions for the loans include putting a new cap in place. We closely monitor [ pending ] expirations and engage with our borrowers to ensure new caps are put in place upon expiration. Currently, there are not any loans in our portfolio in which we are concerned with the borrower's ability to replace an expiring cap.
In addition to interest rate caps, other structural projections for the loans in our portfolio include interest reserves and interest and carry guarantees. As of year-end, the weighted average risk rating of the portfolio was a 3.0. There was no incremental specific CECL allowance taken during the quarter. The general CECL allowance stood at 38 basis points of the loan portfolio's amortized cost basis at December 31, a 2 basis points increase as compared to a year ago.
The increase in general CECL allowance was primarily attributable to a more adverse macroeconomic outlook, particularly in relation to certain asset classes. The negative impact from the macroeconomic outlook was partially offset by overall portfolio seasoning and loan repayment activity outpacing loan fundings. Notably, the outstanding principal balance of the loan portfolio decreased from $8.9 billion to $8.6 billion over the course of the year. As of December 31, our total CECL allowance was 261 basis points of the loan portfolios amortized cost basis.
ARI book value per share, excluding general CECL reserves and depreciation, was $14.73, relatively flat to last quarter. With respect to our borrowings, we are in compliance with all covenants and continue to maintain strong liquidity. ARI repaid $176 million of the remaining outstanding principal balance of convertible notes that came due in October with cash on hand. With this repayment, our next corporate debt maturity is not until 2026.
Picking up on Stuart's remarks with regards to our Washington D.C. hotel, as we continue to monitor the market to determine the optimal time to sell the asset, the hotel was recently pledged into our revolving credit facility, generating an incremental leverage return for ARI. ARI ended the quarter with $278 million of total liquidity comprised of cash on hand on drawing credit capacity on existing facilities and loan proceeds held by the servicer. ARI's debt-to-equity ratio at quarter end was at 3.0x.
And with that, we'd like to open the line for questions. Operator, please go ahead.
[Operator Instructions] Our first question comes from Doug Harter with UBS.
Hoping you could talk a little bit about the potential timing of resolution of your existing problem assets?
Yes. I think in no particular order, Doug, I think as we've indicated previously, with respect to the Atlanta hotel, there has been some dialogue with potential buyers. Don't know that we'll get to the finish line or not. But I think, it's possible that it gets resolved in the first half of this year from -- in terms of there being a sale. I would say, if the dialogues, really, now don't result in a sale, we will probably sort of reassess and whether it makes sense to continue to create more value through operations before bringing it back to market or sort of thinking about relaunching a more formal sales effort. What we're working on now have been sort of -- sort of some dialogues with local players, who knew we might be interested in selling.
With respect to the Mayflower Hotel in D.C., it's actually generating a pretty attractive levered return, as Anastasia mentioned in her comments. And I would say at this point, probably want to see where rates and the overall financing market goes before we do anything formal in terms of trying to sell that asset.
But from a return perspective, selling that asset is really about just removing ROE from our balance sheet. It doesn't change the nature of what we could earn on that capital by a large amount.
I think pivoting to the retail asset in Ohio, we've made a lot of progress from a leasing perspective. We are in the low 90s from an overall occupancy percentage. The asset management team has also done some interesting things to lower our basis a little bit or create more value through some [ outparcel ] ideas and getting entitlements for some additional density.
At the site, we've got a little bit of work to be done with some significant tenants from a renewal perspective, over the next, I'll say, 6 to 12 months. But if successful on that front, again, not knowing where the world will be, but assuming a good environment overall, I think we would look to exit, if possible, sometime in the early part of next year.
And then on the Steinway Building, it's really unit by unit. There's no -- there's no way to force anything in terms of anything from a bulk perspective. So it is literally just trying to grind through it over unit by unit over the coming quarters in several years.
And then obviously, The Brook, which is -- excuse me, the multifamily development in Brooklyn, that will be built through '24, '25, lease up, call it, late '25, '26, and that's when we would envision a chance to exit that asset. We have explored some JV ideas along the way as a way to potentially lower some of our equity commitment, but I would not plan on anything at that time -- at this time.
Our next question comes from Stephen Laws with Raymond James.
I appreciate the comments around Doug's question, Stuart. Certainly helpful as I think about those different assets.
I think there's also a Chicago office loan, maybe you've talked about in the past. Any update on that?
We have 2 office loans in Chicago. Both are well supported by their sponsors. One was a complete, call it, redo and lease up. And I'd say at this point, we are pretty encouraged by the amount of leasing activity taking place at the asset. That's a $100 million commitment that we've got outstanding. We originated it late in 2022. And I would say based on our basis, and based on what we're seeing from initial indication of lease activity, we feel pretty good about that.
And then we've got another asset in Chicago, that's an older asset that we've had in our portfolio, since 2018, I believe. We recently received a modest pay down from the sponsorship. We negotiated an additional paydown plus additional guarantees and would expect the sponsor to continue to support the asset based on dialogue.
Right now, the building itself is about, plus or minus, 75% occupied at this point, but sponsorship is given in every indication. They continue -- they will continue to support the asset.
And like a couple of questions around originations. Certainly, 4Q new investments were above what I was expecting. I think you mentioned somewhat of a pivot in your prepared remarks as far as deploying that capital.
Kind of on the whole, can you talk about your expectations around new originations and repayments this year? Do you expect the portfolio to net grow and increase on the '24? Or do you think kind of over -- not looking at it isolated 1 quarter, maybe over the year, you're going to see originations and repays are more in line each other?
Look, I think we're trying to match them up. I think what you saw at the end of last year was the fact that we had taken a fairly cautious approach through much of 2023 and had built up some liquidity and sort of felt like we had the opportunity to deploy it into transactions. We felt good about.
I think for the rest of this year, I certainly wouldn't in any way be assuming we multiply our deployment by 4. If anything, I think we got ahead of our deployment needs by doing some things at the end of the year or early in this year. And I think pacing for the rest of the year is really sort of dependent, and in some way tied to the question Doug asked, which is when do we free up capital from some of the underperforming assets per se.
And then I think with respect to expected repayments, we're still going to be a little bit cautious, making sure that repayments actually happen before we get too far out over our [ scapes ].
Great. And then lastly, it looks like a little over half of the portfolio is now in Europe. And again, trying not to read too much into 1 quarter, but that's where the new investment activity occurred.
Can you talk about what you like in the European market versus opportunities you're seeing in the U.S.? Or are these just kind of unique deals that presented themselves that were attractive?
I mean certainly, if you look at the asset types, right, which one was a hostel transaction, i.e., as in hostels vacation, not hostile. And then one was a portfolio of pubs. Obviously, a little bit off the run in terms of traditional asset classes, larger deals where ARI was able to participate with other parts of Apollo broadly, where we had knowledge of the sectors from a business perspective, not just a real estate perspective. And I also think the size of their transactions afforded us the ability to create some structure and economics that were interesting.
We are still active in the U.S. as a business overall. The real estate credit team, again, at Apollo did over $10 billion worth of transactions in 2023, and much of that was in the U.S.
So the U.S. continues to be on the radar screen for the business overall. We continue to think about it. or from ARI's perspective. But in this particular case, as we made the decision to put some of our capital to work, I would say the 2 things -- the 2 new transactions in Europe, certainly, were 2 of the more interesting things we were seeing as we thought about achievable risk-adjusted returns. And then obviously, the upsizing which just on an existing transaction in Europe where sponsorship had succeeded from a lease-up perspective.
Our next question comes from Jade Rahmani with KBW.
Just a follow-up to Steve's question around Chicago. On the other office, could you comment on Manhattan and Long Island City? Since Manhattan clearly bifurcated market, but Long Island City, a market where we've seen some pressure there.
Yes. I think, we did a restructuring on the Long Island City asset in 2023. Significant capital came in behind us. It came in from someone that was already junior to us in the capital structure, and certainly is a strong institution in the space overall.
I would say, since that has happened, there's been some leasing that's taken place today. I would say there continues to be interest from tenants, who look at Long Island City as a lower cost option to Manhattan. And I would say the transaction that was done last year, from a restructuring perspectives, was certainly, from our perspective, set us up to have several years of runway and capital available for lease-up and [ TI ] expenses as they occur.
So generally moving in the right direction.
And Jade, this is Scott. I would add. And it's right above the set of subway stop. So it's really centrally located in terms of access all over the city. And historically, the city has a whole bunch of incentives on the tax side, so for people to relocate there. So in addition to being kind of essentially located, it's a low-cost alternative.
And we're really benefiting from a very long lease term. We have like 15, 20-year leases on the 3 major tenants, as well as 100% let retail, which is anchored by Target, if you're familiar with the center.
So as Stuart mentioned, I think us and the sponsorship group is very pleased. A lot of touring, a lot of activities, both by government tenants, which was actually the most recent lease, was a large government New York City tenant. So you have credit there and then a lot of other folks looking for this, really a Class A building.
And then in Manhattan, Jade, we've got 1 exposure. It was a loan we put in place in the first half of 2022. Were the senior mortgage, our last dollar basis is sub $400 a square foot.
There are 3 levels of [indiscernible] beneath us, or sub debt beneath us. I would say at this point, we're sort of at a stage in that transaction where, I think, sponsorship on the equity side is running out of appetite, and we are already in dialogue with those subordinate to us in the capital structure around some sort of restructure injection of capital, et cetera, to give at least some, maybe not all of the sub debt, a chance to play for time.
So it seems like a productive dialogue we should have more in the next -- probably the next time we're on the phone in terms of specifically what's likely to happen.
So a challenging asset, but there's enough subordination where you feel adequately covered?
Sitting here today, yes.
Okay. And then just a bigger picture question, but if you can give a sense -- we get tons of questions about credit performance and people look at, for example, CLOs and they see delinquency issues. They see a lot of modifications.
But ultimately, in your mind, what is the driver of whether a loan stays current or goes into default? In other words, what percentage of interest is funded out of a reserve versus property level cash flows? Does most of it come from an interest reserve that is initially established and later replenished?
It depends, right? So to be clear, right, if you look at our portfolio and you look at our interest, but you also factoring the fact that a lot of what we do are assets in transition, whether it is ground-up development or heavy redevelopment, I think when last we looked, and Hilary could probably get a more current number after the fact, I think approximately 20% of our interest income, maybe slightly higher, is paid out of reserves.
But it's ordinary way structuring when you're doing a construction deal or a predevelopment loan or a significant redevelopment loan that you are baking in the interest cost into the loan.
I think -- I think it's as expected, for lack of a better phrase. And obviously, particularly, when you're doing things that are development or redevelopment in nature, there are no cash flows to cover interest so you're effectively baking it into the loan.
Our next question comes from Rick Shane with JPMorgan.
Anastasia, thank you for the additional detail on caps, et cetera. I'd love to talk a little bit about the dynamics in terms of your borrowers' hedging now, given we are seemingly approaching an inflection in rates. Is the cost of hedging actually starting to come down as the price of caps coming down?
And the second part of this is, does it -- do borrowers have the alternative instead of buying caps of building up the interest reserve instead, sort of self-insurance so that way, if rates come down, they haven't paid away -- they haven't sort of wasted the payment and they can recapture through the reserve?
Scott, do you want to just sort of maybe give like a holistic view of sort of the dialogue with borrowers?
Yes. Look, I do think cap costs have come down. Look, I think every borrower has a different philosophy. We have generally -- and I'm seeing it across the broader real estate platform.
Obviously, as we mentioned, we haven't done many new originations. But across our platform, we have borrowers, who are actually buying in the money caps, so effectively prepaying interest because they want to have more coverage and willing to pay it. We have other borrowers, who really want to buy a way out of the money cap, and it's kind of insurance and requiring it.
Again, part of it also depends on what the coverage is and what the type of leverage that we're doing, and from our underwriting perspective, what kind of interest rate would we have.
But I would say, generally, it's not so much building up an interest reserve. I would say, from a credit perspective, if someone wants to buy or spend less money on the cap, generally, that would be on a deal, where you feel very comfortable with the cash flows and the coverage, and/or you might have some sort of guarantee. So for example, like on construction loans, where you're, by definition, funding that and you kind of look to the forward, and you have a carry guarantee, oftentimes a borrower will want to buy a less expensive, cap [ out ] of the money or something with a shorter term.
Clearly, if you're financing an asset, that is a cash flowing asset and has a lower coverage, if you will, multifamily, you're going to be very focused on what that cap is because you want to make sure that you cover.
Okay. That's...
And then, obviously some borrowing -- are borrowings fixed now, right? I mean that's -- obviously, that's the other thing, if borrowers can fully -- in the market, borrow fixed rate loans.
That's helpful. And then the follow-up to that is -- Anastasia, I apologize. I think you've said that 83% of loans have capped at this point. And I don't recall hearing that metric in the past. Where is that in historical context?
Yes. And it was 81% of the principal balance.
Yes. I think that, Rich, again, if we have a strong sponsor right? And they're willing to -- in some ways, we're better off having them guarantee interest, right? That gives the capital and gets you there, whereas someone is willing to give us a full carry guarantee, that's certainly a trade that we can make.
So I would say on the deals where we don't have a cap, it's because we have some form of other supplemental credit enhancement.
[Operator Instructions] Our next question comes from Steve Delaney with Citizens JMP.
I'd like to go back to Steven, last comment about your foreign market investment. Clearly, that's the most distinctive feature of Apollo ARI. Just noting in your deck here, you have 32% of the portfolio in the U.K. and just 21% in New York City. Just a couple of questions around that. I'm just curious. I know generally, you've had a good performance. Have you had any NPLs or foreclosures in the U.K. or any of the European markets based on your lending activity there?
I appreciate you asking the -- you're like an announcer, where guys like made 20 [ shots ] in a row.
No. To date, we've had very strong performance in Europe. You heard me talk multiple times about why we like Europe because in many ways, we think about Europe the way we do the U.S. in terms of quality of assets, quality of sponsorship, ability to protect ourselves through the legal system.
It's not to say, we haven't had assets, where sponsorship did not achieve business plan. But in those cases, the value of the underlying real estate relative to our loan was sufficient to make sure we were made whole on our transaction.
Yes. What's the -- gosh, everything is -- every loan is unique. Everything is a story, right? Every borrower has a person at different personality.
But is there one like principle of doing business or custom that gives -- in the U.K., that gives lenders more control over borrowers? Is there anything just technical like that, that helps make that a -- maybe I'll use the word, safer lending market than the U.S.?
I wouldn't say -- this is Scott. I wouldn't say it's safer because obviously, people can lose money on loans and anything in London just as much as they can here.
I would say there are some norms over there around kind of ongoing covenants that you don't really see here. So whereas in the U.S., you generally, obviously, we've always structured our deals with ongoing cash triggers and maybe extension tests in Europe and the U.K. You would often see, in addition to those type of triggers, we actually have financial covenants that if they're breached, bring everyone to the table, I would say, rule of law and enforcements is obviously very strong there.
And I would just say, London historically, it's just been a center of attracting capital. So even office right now, I think, I read somewhere, there's like GBP 2 billion of office under offer. Across our portfolio, we recently got refinanced in some office buildings that were outside the ARI portfolio in London.
So I just think it's a liquid market that's attracting people from Asia to other parts of Europe, the U.S. And we have a large team there, so we like it. But again, also, we look across Europe as well, it's really, for us, the power of the platform. It's really how we look at it.
Well, congrats on how you've taken advantage of that and a solid close to 2023.
Thank you. I would now like to turn the call back over to Mr. Rothstein for any closing remarks.
Thank you all who participated on the call this morning. Obviously, to the extent, there are follow-up questions. Myself, Hilary and Anastasia are always available to talk. Thanks, everybody.
Thank you. Thank you for your participation. You may now disconnect.