Apollo Commercial Real Estate Finance (ARI) is a mortgage real estate investment trust [mREIT] that originates and invests in commercial real estate mortgage loans and invests in commercial mortgage-backed securities [CMBS]. The initial IPO was completed on September 29, 2009, and this company has a rather short history. However ARI is externally managed by a subsidiary of Apollo Global Management (APO), which has been around for 22 years and indirectly manages the better known residential mREIT Apollo Residential Mortgage (AMTG). ARI belongs to a small category of mREITs that is often overlooked by retail investors: the commercial mREITs. Its competitors are, amongst others, Blackstone Mortgage Trust (BXMT), Ares Commercial Real Estate (ACRE), Starwood Property Trust (STWD), Colony Financial (CLNY), etc. Commercial mREITs as a class are definitely worth a look right now, as their share prices have taken a serious hit these past four months in the wake of Ben Bernanke’s speech regarding quantitative easing tapering. However, ARI’s book value is only marginally impacted by interest-rate volatility, unlike most residential mREITs, and consequently the recent sell-off appears overdone. Going forward, management is confident that the quarterly dividend (with a yield of about 10%) is sustainable, and that book value should not be significantly affected by rising interest rates. Moreover, should these rates continue to rise, as anticipated by most analysts, this is likely to result in an increase in ARI’s earnings. In short, like many others, I believe ARI is a buy, and that the recent price action constitutes an opportunity for income-oriented investors.
The financial results pertaining to Apollo Commercial Real Estate Finance and mentioned in the following sections are taken from the second quarter of 2013 financial report
Apollo Commercial Real Estate Finance: an Overview
Like residential mREITs, Apollo Commercial Real Estate Finance funds its investments (loans and CMBS) and the loans it issues through repurchase agreements with financial institutions and through share issuances. ARI currently has repurchase agreements with only two companies: Wells Fargo and JPMorgan Chase. The latest share issuance occurred in March and raised $ 148.5 million. However, unlike mREIT bellwethers Annaly Capital Management (NLY) and American Capital Agency Corporation (AGNC), repurchase agreements constitute only a minor part of ARI’s liabilities. Therefore ARI sports a lower leverage: as of June 30, 2013, the company’s debt-to-equity ratio was a paltry 0.4. This is a far cry from the 8.5 ratio reached by AGNC. Apollo Commercial can afford to employ a lower leverage because interest rates on commercial loans are, on average, higher than on residential loans.
Why Invest in Commercial Mortgages?
It appears to be a good time to invest in commercial mortgage loans, as the US economy is on a slow, but firm, road to recovery. Commercial real estate mortgages reached a pre-crisis balance of about $ 6.5 trillion, but following the de-leveraging resulting from the financial collapse of 2007-2008, this same balance was an anemic $ 3.1 trillion in 2012. Similarly, the commercial mortgage bankers origination index peaked in 2007, and then dropped by roughly 65% in 2008, while the commercial loan delinquency rates increased dramatically and reached a plateau at about 8%. At its peak in 2007, more than $ 230 billion in CMBS were originated annually in the United States, but new issues plunged to a pathetic $ 12 billion the following year and to just $ 3 billion in 2009. In lockstep with the drop in mortgage values and CMBS issuances, commercial property prices dropped more than home property prices in 2008. In short, both commercial mortgage loans and commercial property values were deeply and negatively impacted by the Great Recession.
However, commercial property values have slowly recovered since then and are now only 11% below their pre-recession levels (according to the NCREIF property index, NPI). The Moody’s/REAL US commercial property price index paints a slightly different picture, where the prices are still about 25% lower than their peak reached in the fourth quarter of 2007, but are a compelling 26% higher than the trough of the fourth quarter of 2009. Conversely, in July 2013, the Green Street Commercial Property price index was 4 percent higher than the peak reached in August 2007. Despite the disparities between these three indices, they all point to a real recovery in the commercial real-estate sector, and this recovery is expected to continue.
Since the crash, the volume of commercial real-estate sales has also risen steadily, and commercial mortgage originations grew 64.0 percent year-on-year to $ 195.0 billion in 2011, and continued to rise in 2012. The recovering US economy is creating demand for commercial mortgages, and more than $ 1 trillion of commercial loans are expected to mature in the coming years: the financing needed to make those payments will create compelling opportunities (provided the US economy continues its recovery, otherwise opportunities will quickly fade and we might see a spike in defaults). In short, the US economic recovery bodes well for commercial real estate and commercial mortgage loans. These data are reason enough to contemplate investing in ARI.
Finally, an interesting fact is that the correlation between the 10-year Treasury yield and commercial mortgage yields is a relatively low 0.46 (see Table on page 2 of this document). In other words, yields on commercial mortgage loans do not evolve in perfect lockstep with the Treasury yields, which means that unlike most residential mortgage loans they should provide better protection in terms of MBS prices from rising Treasury rates.
Commercial Mortgages vs. Residential Mortgages
Commercial mortgages differ from better known residential mortgages in significant ways, and a few need to be mentioned here to make it easier to understand ARI’s business. First, commercial mortgages are not backed by governmental entities such as Fannie Mae or Freddie Mac. Also, they carry more credit risks, similarly to the non-agency residential mortgages. A sizeable down payment is required: unlike residential mortgages, you cannot obtain a commercial mortgage with a zero down payment. Moreover, commercial mortgages are usually non-recourse: in the event of a default, the lender cannot seize any asset of the borrower other than the collateral (the property). Therefore, the credit risk of this property is often more important than the credit risk of the borrower.
Another major difference is that commercial mortgages usually require a balloon payment: unlike residential mortgages, they are not fully amortized over the term of the loan, and the principal balance is due after a specific time period. For the first few years following origination, the borrower repays interest and principal on a monthly basis at the stated interest rate. Then, the borrower has to repay the entire remaining balance in one big — balloon — payment. Usually, this balloon payment is made by refinancing the mortgage. However, the ability to refinance is strongly dependent on the prevalent market conditions at the time: if the value of the collateral has dropped, as a result of a recession for instance, refinancing will prove tricky. This adds another risk to commercial mortgages as it is always difficult to anticipate market conditions a few years down the road. This also explains why the coming wave of commercial mortgage refinancing has some analysts pretty worried. Any investor in ARI should keep an eye on the maturity of its commercial mortgages and follow the evolution of commercial-property value.
Finally, a third significant difference between commercial and residential mortgages is that the prepayment risk is usually low for commercial loans: they come with restrictions with respect to prepayment. Often, prepayment is either simply prohibited, or comes with a yield maintenance provision (should the loan be prepaid, the borrower would be required to compensate the lender for the resulting loss of money). Therefore the CPR (constant prepayment rate) is not really a useful metric for commercial mREITs, unlike residential mREITs, and CMBS have a minimal negative convexity compared to residential MBS.
Apollo Commercial Real Estate Portfolio
Apollo Commercial originates and invests in commercial mortgage loans for hotels, offices, retail shopping malls, industrial property, and multi-family housings. The collaterals for the loans (real-estate properties) are mainly located on the East Coast of the US (in the states of Maryland, Massachusetts, North Carolina, Virginia, and New York), but also in California, Missouri, and Michigan… About 49% of the company’s assets are tied to New York City. About 19.5% of ARI’s portfolio are first mortgage loans, while 48.4% are subordinate loans. Therefore, 67.9% of ARI’s portfolio are mortgages underwritten by the company, rather than mortgage-backed securities. This tends to lower the volatility in book value as the loans are held to maturity. Only 32.1% of ARI’s gross assets are commercial MBS. Of those, 70% have a AAA credit rating, and the remnant 30% are Hilton-CMBS, i.e. MBS backed by loans for which the collaterals are assets of Hilton Worldwide.
The five commercial mortgage loans (first mortgages, i.e. loans that have priority over all other claims in the event of a default) in the portfolio have a weighted average coupon of 7.84% and short maturities ranging from 1.7 to 3 years (some have fixed rates, some have floating rates). Unlike home mortgages, commercial mortgage loans usually have maturities of 10 years, or less.
ARI also issues and invests in subordinate loans, mainly mezzanine loans, which are intrinsically riskier than first mortgage loans but therefore have a higher coupon: the weighted average coupon of the 14 loans currently in the portfolio is 12.23%, with, again, a combination of fixed and floating rates. In the event of a default by the borrower, the mezzanine loan is (partly) repaid only after all of the senior claims. The maturities on these subordinate loans range from 1 to 10 years.
Finally, ARI invests in AAA-rated CMBS, which have an average coupon of 5.6% and a remaining weighted average life of 1.8 years, and in Hilton CMBS. The Hilton CMBS has a current interest rate of one-month LIBOR+2.30%, scheduled to increase to LIBOR+3.30% on November 12, 2013 and then to LIBOR+3.80% on November 12, 2014. The Hilton CMBS has a repayment schedule roughly equivalent to a 16-year amortization schedule, a yield of 5.6%, and a remaining weighted average life of 2.6 years.
Overall, the remaining weighted average life of ARI’s portfolio is, as of June 30, 2013, only 3.0 years (a rather short duration). About 73.5% of ARI’s loan face value will reach maturity by the end of 2017. Finally, it can be argued that ARI is well-positioned in a rising interest rate environment because 34% of its loan position is made of floating-rate mortgages, which should translate into increased yields in the coming quarters.
Two measures of default risk are usually considered when analyzing commercial mortgages: the weighted average LTV (loan-to-value, i.e. ratio of the mortgage loan to the appraised value of the real-estate property) and DSCR (debt service coverage ratio, i.e. the net operating income divided by the monthly interest and principal payment). LTV lower than 75% and DSCR higher than 1.30 are considered lower risks. Unfortunately, ARI does not provide the DSCRs of the borrowers in its quarterly financial report. It does, however, provide a loan average weighted (ending) LTV, which was 56% as of June 30, 2013: this is considered safe (but is slightly higher than during first quarter, when it was 53.6%). Of course, the LTV of mezzanine loans is, on average, higher (and even reaches 78% in one instance). Overall though, ARI’s management does not seem to be taking undue risk. The weighted average IRR (internal rate of return, which is an estimate of the annualized effective return rate) of the portfolio was a healthy 14.2% during the second quarter. This is lower than the 15% of second quarter of 2012, but has been roughly stable for the past two quarters.
ARI’s Hedges and Book-Value Preservation
ARI uses swap agreements and interest rate caps to hedge part of its interest payments on the repurchase agreements. The borrowings under repurchase agreements have floating interest rates: the interests paid by ARI are tied to some LIBOR rate. Therefore, should the LIBOR increase, ARI would have to pay higher interests and consequently see its earnings decrease. The swaps and caps used by ARI are a way to protect the company against such a rise in its cost of funding. Interest rate caps are derivative instruments in which the buyer, ARI, receives payments if the interest rates exceed an agreed-upon value (typically the LIBOR plus some basis points). The total notional value of swaps and caps at the end of the second quarter of 2013 covered 88.3% of the borrowings.
Apollo Commercial uses swaps and caps as financing hedges, but unlike mREITs like NLY or AGNC, it does not appear that ARI is using any duration hedge to reduce its exposition to interest-rate risk (see this article by Seeking Alpha contributor REIT Analyst for an explanation on hedging techniques). No swaps, swaptions, or Treasury shorts are mentioned in the quarterly financial report. This is not surprising as the risk for ARI’s book value resides not so much in interest rates as in credit quality. Only 32.1% of ARI’s portfolio are CMBS, and they have a short remaining weighted average life (only 1.8 years for the AAA-CMBS). Unlike the CMBS, the loans in ARI’s portfolio are not trading securities: they are held to maturity. Therefore, ARI does not mark its loans to market (mark-to-market accounting means that the fair value of the loan is based on current market price). Consequently, the reported book value of ARI is relatively immune to interest-rate volatility. Not using mark-to-market accounting for held-to-maturity loans is acceptable (FASB statement 115).
ARI’s Second Quarter of 2013 Financial Results
ARI released its second quarter of 2013 financial results on July 31, and they were rather good. First, as of June 30, ARI has a $ 733.431 million portfolio with a weighted average yield of 9.9%. ARI is therefore much smaller than AGNC and its $ 91.7 billion of agency securities. The second quarter operating EPS was $ 0.31, in line with analysts’ expectations. The book value saw a marginal drop of 0.9% from $ 16.41 (on March 31, 2013) to $ 16.26 (on June 30, 2013). Using fair-value accounting (i.e. mark-to-market value of assets instead of carrying value, which is the original cost of the loans minus amortization) actually produces a slightly higher book value of $ 16.55 as of June 30, 2013.
Despite this stability in the book value, the share price of ARI dropped by 14% these past 3 months (as of August 9, 2013), which really looks like an over-reaction and spells opportunity as far as I am concerned. Moreover, with an announced quarterly dividend of $ 0.40, the dividend yield of ARI is a compelling 10.26%.
Now, of course, the question is whether or not this dividend is sustainable in the long term. Unfortunately, the latest EPS does not cover it, but recent and upcoming loan originations (management still had $ 60-70 million to deploy at the end of second quarter) and near-term net-lease opportunities are expected to place the earnings above the $ 0.40 quarterly dividend (according to the management earnings conference call of August 1, 2013). Indeed, management intends to add net-lease assets to its portfolio (a net-lease property is a property where the tenant agrees to pay, in addition to the rent, some expenses normally paid by the owner. Net-lease properties usually have stable and predictable returns). Apollo Commercial is considering a joint venture with a major industry player, whose name has not yet been unveiled, and a capital allocation of $ 25 to $ 50 million. This partnership is expected to further increase the EPS. Management appears confident that the dividend is sustainable, as the quarterly earnings should exceed the dividend in the coming quarters. A (most likely) stable dividend and the fact that ARI is currently trading at a discount to book value of about 4% (vs. a 10% premium in December 2012), make me confident that ARI is a buy. Of course, the growth potential might be limited, but a 10% dividend yield and a stable book value seem like good reasons to buy some shares if you are an income-oriented investor.
Again, compared to investor favorite AGNC, Apollo Commercial bears a minimal interest-rate risk, but has a higher credit risk. However, in the current environment where interest rates are expected to rise while the economy seems to be improving (albeit at a snail’s pace), trading interest-rate risk for credit risk seems reasonable: loan defaults are expected to decrease in an improving economy.
Finally, let’s mention that during the second quarter ARI closed two mezzanine loans: a $ 32 million fixed-rate loan with a 10-year term, a LTV of 75%, and an underwritten IRR of 12% (in line with past loans), and a $ 44 million floating-rate mezzanine loan with a 15-month term, a 78% LTV, and a 14% IRR. Conversely, there was a principal repayment on a $ 15 million mezzanine loan, and Apollo Commercial received $ 1.2 million yield maintenance fees. The IRR realized on this investment is a healthy 19%.
Conclusion
Not all mREITs are created equal, and commercial mREIT ARI seems like a good bet in the current environment of rising interest rates and recovering US economy. ARI’s book value is only marginally sensitive to changes in interest rates, because a majority of its assets are loans held to maturity, and the rest are CMBS with a rather short duration. A significant portion of floating-rate loans in its portfolio should produce higher earnings if Treasury rates continue to rise. Even though the second quarter results are in line with expectations, the EPS does not cover the quarterly dividend, but short to mid-term opportunities (net-lease joint venture with a major industry player, and a significant amount of capital to deploy in the coming months) should result in higher EPS in the coming quarters. ARI is externally managed by a competent team from Apollo Global Management. Investors in ARI should sleep much better at night than those involved in agency-only residential mREITs, which are likely to experience more book-value volatility as the Treasury rates continue their ascent. The dividend yield, currently around 10.26%, is lower than the yield of, say, AGNC, but it does appear sustainable. For what it’s worth, I believe ARI is a buy right now.