Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) Q4 2023 Earnings Call Transcript

Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) Q4 2023 Earnings Call Transcript February 7, 2024

Apollo Commercial Real Estate Finance, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: 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 this time, I’d like to turn the call over to the company’s Chief Executive Officer, Stuart Rothstein.

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 am 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 lot 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 two 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 three 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 question over to Anastasia.

Anastasia Mironova: 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 stock. 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 three 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 cap 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 protections 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 loans 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 repeated $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 to 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.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Doug Harter with UBS. You may proceed.

Doug Harter: Thanks, and good morning. Hoping you could talk a little bit about the potential timing of resolution of your existing problem assets?

Stuart Rothstein: 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 will 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 is no – there is 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.

Doug Harter: Great. Thank you, Stuart.

Stuart Rothstein: Sure.

Operator: Thank you. [Operator Instructions] Our next question comes from Stephen Laws with Raymond James. You may proceed.

Stephen Laws: Hi, good morning. I appreciate the comments around Doug’s question, Stuart. Certainly, helpful as I think about those different assets. I think there is also a Chicago office loan, maybe you’ve talked about in the past. Any update on that?

Stuart Rothstein: We have two office loans in Chicago. Both are well supported by their sponsors. One is 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.

Stephen Laws: Thanks. And 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 one quarter, maybe over the year, you’re going to see originations and repays more in-line each other?

Stuart Rothstein: 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 are still going to be a little bit cautious making sure that repayments actually happen before we get too far out over our skits.

Stephen Laws: 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 one 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?

Stuart Rothstein: 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 part. 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 the 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 two things – the two new transactions in Europe, certainly, were two 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.

Stephen Laws: Great. Thanks for the comments this morning, Stuart.

Stuart Rothstein: Sure.

Operator: Thank you. [Operator Instructions] Our next question comes from Jade Rahmani with KBW. You may proceed.

Jade Rahmani: Thank you very much. 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.

Stuart Rothstein: 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 is 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 perspective, 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.

Scott Weiner: Yes. And Jade, this is Scott, I would add. And it’s right above the 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 for people to relocate there. So, in addition to being kind of essentially located, it’s a low-cost alternative. And we are really benefiting from a very long lease term. We have like 15-year, 20-year leases on the three major tenants, as well as 100% let retail which is anchored by Target, if you are 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…

Stuart Rothstein: And then in Manhattan, Jade, we have got one exposure. It was a loan we put in place in the first half of 2022. We are the senior mortgage. Our last dollar basis is sub-$400 a square foot. There are three levels of mezz beneath us, or sub-debt beneath us. I would say at this point, we are 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, etcetera, 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 are on the phone in terms of specifically what’s likely to happen.