Apollo Commercial Real Estate Finance, Inc. (ARI) Earnings Call Transcript & Summary

Welcome to Citi's 2021 Virtual Property CEO Conference. I'm Arren Cyganovich with Citi Research. And we're pleased to have with us Apollo Commercial Real Estate Finance, and CEO, Stuart Rothstein. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. [Operator Instructions]

So Stuart, we'll turn over to you, and you can talk a little bit about the company. And just to start off, coming out of the pandemic, if an investor were to choose only 1 real estate stock to own, what are 3 reasons why they should invest in ARI?

Thanks, Arren. Look, I think quickly, just from a financial analysis perspective, a stock that traded at 115 to 120x book value pre-pandemic is now trading at somewhere between 0.85 and 0.9x book value with a 10% dividend yield, which we consider to be highly attractive in the low interest rate environment. I think you have the benefit of the full Apollo platform behind the company. So a $450 billion asset manager with best-in-class relationships with borrowers, brokers and other financial institutions that drives a lot of business and value for ARI. And then I think lastly, relative to the peer group, we are the only commercial mortgage REIT that has just a management fee, no incentive fee, which we think furthers the alignment with our shareholders.

Great. Very helpful. So I guess, thinking about where we were a year ago, in Florida, in person at the conference, and now we are virtual here. Maybe you can talk a little bit about how the past year has kind of moved for your business, how you've evolved and where you see the business today?

Yes. I mean, I think it's really been sort of a tale of 2 different parts of the pandemic. I think the first 6 months or so, which I would define is, call it, this conference last year through Labor Day, I think the business and the sector overall was very much around what I would call defense, which was a high degree of focus on staying liquid, and I think in most cases, resulted in putting excess liquidity on the balance sheet. I think there was a primary focus from a portfolio perspective on asset management issues within the portfolio, regular dialogue with borrowers, not a lot of focus on adding anything new to the portfolio. And I think we handled that extremely well, consistently maintained excess liquidity on the balance sheet, while at the same time, also maintaining a large pool of unencumbered assets, which we could always use, if needed, for additional liquidity. We weren't forced to do anything unnatural in terms of bringing additional capital into the company, either through private or public measures. And from an asset management perspective, I think we've been very candid, very upfront in terms of addressing those transactions that are most on our mindset within the portfolio. I think we've successfully restructured a few to get them back to performing. We've sold a fair number of assets. We sold over $650 million of loans to both create liquidity and also address some challenges within the portfolio. But I think we worked very constructively with our borrowers in combining their ongoing commitment to an asset through additional equity contributions with giving them some lender flexibility. I think post Labor Day, I think the real estate market in general has really shifted much more towards where it was pre-pandemic. Obviously, we can debate valuations. But just in terms of transaction levels, deal activity, look, I think the sector overall still benefits from record levels of dry powder. I think, depending on who you read, there's approximately $300 billion in closed-end real estate private equity funds looking for a home. Low interest rate environment, despite the recent volatility in the 10-year is still very beneficial for the sector. And I think there's a -- certainly a more optimistic view with respect to pandemic management, vaccine rollout and the economy on a path to recovery. So over the last 6 months, we've been much more focused on playing offense in the sense that we were maintaining excess liquidity, but we're slowly but surely managing it down. We're looking at new opportunities to add to the portfolio. We announced on our Q1 earnings call that we will have several closings in the first quarter or certainly before our next earnings call that add to the portfolio. So there's definitely much more of a focus on getting back to what the business was right before the pandemic.

Great. The -- talking about the kind of the -- seeing the market open back up, maybe you could talk a little bit about the conversations you're having with sponsors these days. What areas are -- you're seeing the most activity and the most demand for your capital over the near term?

Yes. I mean, I think, look, at a high level, most of the sponsors or borrowers that we work with that are sort of the best-in-class across this space, many of them, if not all of them, try not to be property type specific, right? They tend to look for value where they could find it. As we sit here today, probably the sector that has had the most activity in the sense that properties have adjusted, and there's sort of a meeting of the minds between buyers and sellers in terms of where value is, seems to be around the hospitality sector today. I think whether it's leisure or destination, which has been less impact or business-centric, which has obviously been more impacted, the market has seemed to settle around somewhere between a 10% to 20%, 25% drop in value. And you're seeing real deal activity there. So there's things for us to look at there. Clearly, maybe one of the newer sectors that is clearly perceived as a winner post pandemic is the life sciences sector. Obviously, there's an expectation that government sponsorship will lead to a lot of spending in biotech over the coming years. And while there certainly has been an active life sciences sector historically, I would say you're seeing much more deal flow right now in people taking legacy office assets with business plans to convert them to life science uses, which is a fairly heavy CapEx spend. And then I'd say the property sector that has the most smart money on both sides of the equation, but still one where we're actively pursuing transactions would be the office sector. I think there's certainly those in the camp of what we've learned about working remotely will create radical changes in the way office space is used, and that perceives one path towards value. And then there's others who think what we've learned working remotely has been a nice gain for the last year, but everybody wants to get back to the office. And that obviously leads to a different conclusion on value. So there's a lot of debate. But you're definitely starting to see people starting to put capital behind their view on the office side. I would say the one area that we continue to shy away from is on the retail side of things. I think we'll look back years from now, and I'm sure the pandemic will get blamed for a lot of what's going on in retail. I think all the pandemic did, arguably in a good way, was just accelerate some of the challenges that retail was facing pre-pandemic and maybe force people to truly think what retail is going to be over the next 5 to 10 years, whether existing retail is more of a distribution model, whether it's more of a showroom model. I think it's still evolving. I would say, from our perspective, it's too hard right now to figure out what value is for retail. So we're tending to avoid it from a lending perspective.

Okay. The comment you made about offices, it's definitely, I'm sure, an area that people will be debating. I know I'm anxious to get back in the office, maybe not 5 days a week, but at least the majority of the week. What are you seeing from your own portfolio? And what are sponsors feeling for the most part? Do you feel like they're saying that we're going to get back to kind of closer to where we were in the normal post-pandemic?

I think that is what sponsors are saying. Whether they truly believe that or they're just talking their books, that is sort of the challenge of figuring out from an underwriting perspective. Certainly -- look, for the deals we're in, we get the weekly, monthly sort of lease activity reports, touring reports. Certainly sitting here today, people are clearly coming off the sidelines and starting to think about their space needs and making decisions. I think depending on the city, there are subtleties that impact what is going on in various locations. It's fair for everyone. So I obviously bring the Apollo bias to this, which is being a New York-based company, that clearly in the camp that I think we've learned a lot about working remotely. I think, as you commented in your question, I don't know if we go back to the office 5 days a week, but I think there's a bias towards being back in the office more often than not. And certainly, in terms of training younger talent, attracting younger talent, creating a culture, I think we have a greater appreciation of the importance of people being together. So I think we sit here today on the margin a little bit more optimistic about what it portends for space usage in cities going forward. That being said, it's all within the range depending on the city of expecting rents are going to be down 10% to 15% from where they were right before the pandemic. I think there'll be some cities that are winners. And you could think of places like Austin or Salt Lake City or Denver that are pulling people from higher cost of living, higher tax areas on the coast into locations that are more advantageous for businesses to be in and sort of offer a attractive long-term lifestyle perspective for younger people. But we do a lot of surveys at Apollo, and we sort of committed from the perspective that the general perception of the young talent working at Apollo is that they want the urban environment. They want to be in an office with their colleagues, having a social life with their colleagues after work. So I think we're feeling better about it today than we did 4 or 5 months ago. And certainly, the level of lease activity and touring activity has picked up pretty significantly in the last few months.

Yes. Social life with colleagues, that would be a nice change of pace. Yes, I think the other area of your portfolio that seems a little bit underrepresented is multifamily. Is there a particular reason why you've been a little bit under-invested in multifamily relative to your peers?

I think there's 2 primary reasons. I think one answer is historically, just tough to compete with Fannie and Freddie from a cost perspective. We did do -- to the extent we were able to play in multifamily, it tended to be more bridge during lease-up to a Fannie and Freddie take-out eventually. We've done that episodically, for the most part, in and around the Tri-state area. I think the other sort of reason we've tended to avoid it and not denying that people have made significant amounts of money is overall, both equity side and credit side of our business, we've never been particularly big believers in garden-style multifamily sort of Southeast through Southwestern part of the U.S., not that there's not demand for it, not that builders haven't made a lot of profits doing it. There's -- we could debate what the residual value is given that there's not a lot of cost that goes into the construction. So at the end of the day, we look at it a lot. And probably, the time when we missed it most was probably 2009 through 2012, and you could have done some really interesting things. And given where rates ultimately ended up going, it would have been nice to build a sizable portfolio of multifamily then. But in the last few years, we've looked that our ability to play has been more episodic in terms of -- relative to other property sites.

What about today? There's still some concern about deurbanization trends and seeing rents in -- at least in major urban centers coming down. Is there some opportunities that are starting to present themselves in this environment?

I think there is. Again, I think the -- again, maybe too much of a New York perspective. But I think we've been pretty surprised by what we've seen over the last 3-plus months in New York in terms of the number of for-sale condos that have been put in -- under contract. And that's a sector where we do have a decent-sized portfolio and receive weekly updates on sales activity, and the number of units that have been sold over the last few months is pretty dramatic. So I would say, certainly, the -- I hate doing age brackets, but certainly the cohort that's probably 30-plus that has the financial ability to buy a condo in New York is certainly committing to being back in the city. And again, I think -- that, I think, is driven by very low interest rates, low financing costs, but also, I think, people in some respects saw their financial assets recover pretty well last year and now they want to move those financial assets out of the market into a hard asset. And then my sense on the lease on the multifamily side is companies and cities are going to go down the path of bringing their employees back into the office. My guess is sort of around Labor Day, given sort of vaccine rollout and whatnot. Again, it might not be 5 days a week. It might be 4 days, it might be 3 days. But I think with that in mind, my sense is we're going to start seeing a significant pickup in lease-up activity over the coming months, particularly, in some respects, to your point, as people, at least at a minimum, want to get back to being in and around their colleagues. And even if they're not in the office immediately, there's still the ability to be in a city and share a meal outside, share a drink outside. So I think you're going to see more of that. I think the one potential outlier to everything I'm saying from an urban perspective, we've never been a big player in the market of San Francisco. We've looked at it lot. I think San Francisco just might have some unique challenges just given that it had a dramatic cost of living and dramatic lack of infrastructure problem before the pandemic. And the pandemic might, in a good way, be the right way to sort of hit the pressure or lease valve a little bit and let things settle out there. So I'd say, still remain a little cautious about that market.

Got it. And you have a pretty large amount of overseas investments as well, a nice mix in the U.K. and some other European countries. What are you seeing from the opportunities internationally versus in the U.S. market?

Yes. I mean, I think -- look, I think Europe is about 1/3 of our portfolio today, plus or minus. It's all within Western Europe because obviously as lenders were very rule of law focused. We've got a team of about 10 people in London that cover Europe for us from a lending perspective. So we've got the market well covered. And ultimately, our initial entrée into Europe was, in many respects, following the sponsors and borrowers that we work with here in the U.S. to do their transactions for them in Europe. Europe is a little bit more stringent with respect to the U.S. in terms of lockdowns and how they've handled the pandemic. But you're starting to see deal activity sort of look through what's going on from a lockdown perspective, and people are starting to make investments with a longer-term time horizon. And we still continue to be constructive on our ability to find transactions over there. I think if you look at our footprint in Europe over the last 3 years or so, it's gone from being very London-centric to expanding into Italy, Germany. We've done deals in Paris before. I think it's -- I think our footprint has broadened. I think it's broadened as our reputation in Europe has expanded and our relationships with brokers and borrowers have expanded. I think from a valuation perspective, it tends to be a -- on the margin, slightly less competitive market than the U.S. So I'd say we feel pretty optimistic about our ability to find things over there that work from a return perspective.

Okay. We've got a question from an investor online here. How does the resurgence of the CLO market affect your business? Is it a threat to loan production or an opportunity on the right side of the balance sheet or maybe a little of both?

Great question. And certainly, it's come back fairly strongly. Starting on the right side first. We have tended as a lender to not be a user of the CRE CLO market. For the most part, most of what we do in our portfolio doesn't lend itself to that market. We tend to do things that -- I would say, the business plans in and around what we're lending against tend to be a little bit more involved. From our perspective, we think, given our ability to underwrite, given our ability to structure around complexity, we can get paid for doing the work. But they tend to be transactions that more often than not might be a little harder to understand. So they don't lend themselves to the CRE CLO market. We've also been quite comfortable with the notion that we can get pretty attractive financings from our bank lenders, so we haven't aggressively pursued that market. And I'm not sure that's going to change going forward. I think in terms of competition, I'm not sure it really changes the competitive balance one way or another. I think whether it is money center banks, others in the mortgage REIT space, real estate credit funds, general credit funds that look at real estate, those who are originating for CRE CLOs, at no point in the 5 years leading up to the pandemic, we're sitting here today, has the market felt noncompetitive. And I think from our perspective, we've got a 12-year track record of -- as a group, we've done about $45 billion worth of deals. On behalf of ARI, we've done about $16 billion to $17 billion worth of deals. Given our relationships with brokers, with borrowers, the amount of repeat business that we do as well as, I think, the reputation that the team now has in the market, we expect competition. We're comfortable competing, but pretty confident we'll win our fair share of business and find things that work for the portfolio. And yes, we compete with those who are CRE CLO focused, but we don't think what they do in any way sort of changes the balance of competition or dramatically alters the economics available in the business.

I guess thinking about that from the right side of the balance sheet, there's been a push from a lot of managements and investors towards more nonmark-to-market type of financing. Maybe you could talk a little bit about if you're not keen on financing with CLO, what areas you can get the benefit of having a nonmark-to-market financing?

Yes. We've been -- from our perspective, so going back to where you and I started with liquidity. Look, I think one of the real strengths of our balance sheet that occurred when the pandemic hit was that we have about $1 billion of unencumbered assets that just sit there with no leverage against them, which is remarkably valuable from a liquidity perspective, if you think dire scenarios when you're looking for anything to post as collateral that you would use for liquidity purposes. And we very much like the notion of adding duration to our corporate leverage, and where possible, unencumbering assets. So we've been a frequent user of the convertible notes market, which, while the conversion prices are well north of book value, and we'd be perfectly happy to convert at that price, we really look at it as very cost-effective, no covenant 5-year corporate credit. And then we've also successfully accessed the Term Loan B market with our corporate rating, which has given us 7-year nonmark-to-market corporate leverage. So we've succeeded there. I think we'll continue to explore both of those markets. I think given the rating we have, we would also think about the regular way unsecured debt market, again, focused on adding duration to our leverage, but also unencumbered assets and just putting assets off to the side that we don't finance on a one-off basis, but they're there if we ever need them as markets ebb and flow. And then the other thing I'd say is, while not a traditional player in the CRE CLO market, we have been able to use what's created there to -- on a one-off basis, creates what I would call, private equivalents with our banks that replicate what goes on in that market. And most notably, we did a pretty sizable deal with our largest bank lender in Europe in the middle of pandemic where we effectively basically took a traditional repo structure and turned it much more into a private securitization, which gives us a lot more flexibility around the issues you referred to, which is sort of avoiding margin calls or other mark-to-market risks to our financing.

So in terms of the assets that you have that are unencumbered, and definitely, we saw folks that had unencumbered assets definitely benefited during periods of stress. Is that coming from kind of the proportion of the loans that you have that are subordinate? You've really made a good stride over the past several years to reduce the amount of subordinate loans that you have in the portfolio towards more first lean, first mortgage percentage. Maybe just talk about what types of assets you have on that unencumbered side?

Yes. So look, our operating philosophy from day 1 has been we will not put asset-specific leverage on subordinate loans. So we've never financed them even though they are clearly financeable based on conversations we've had with another -- a number of potential counterparties. To your point, we've pretty aggressively managed down the amount of subordinate loans we have in the portfolio. If you look at the portfolio today, it's about 85% first mortgage. It's only about 15% subordinate loans. But you could assume that all of those subordinate loans are unencumbered. And then as we are able to add more, call it, corporate leverage to the balance sheet, we unencumber assets that have previously been financed, which are senior mortgages. So we're in the market, it's public, with a Term Loan B transaction. Right now, it's roughly a $300 million transaction. If that successfully gets to the finish line, plus or minus, that allows us to unencumber $500 million or so of first mortgages that will then just sit on the balance sheet with no leveraging against them -- no specific leverage against them.

It's interesting. You bring up the term loan, that was one of the other questions we got from an investor is what was the driver of that? Is that primarily the drivers to free up some assets on the balance sheet for -- to be unencumbered?

I think it's a combination of creating 7-year leverage a pretty attractive pricing and unencumber assets. I think if you look at what's gone on in the term loan market over the last 3 or 4 months, particularly as rates keep coming in, there's a strong bid for high yield, there's a strong bid for investment grade, people are looking wherever they can find yield, fund flows into CLOs have been very strong, so the term loan B market has just been an attractive time to be an issuer. And from our perspective, it's very consistent with what I articulated in terms of creating both duration as well as unencumbering assets.

Okay. And one of the benefits of LIBOR being so low over the past year is that it's creating a lot of excess income from LIBOR floors we're seeing across in -- all of your peers. What do you think about in terms of earnings power over the next few years? If rates stay relatively low level and you are kind of rotating off of the LIBOR floor assets as you have those repay and you reinvest?

Yes. Look, I think it's a fair question. I think the one way I would answer it at the sort of the macro level is from an underwriting perspective, there's not a lot of difference between how we're thinking about underwriting from an ROE perspective today versus what we were generating a couple of years ago. And that reflects the fact that we expect lower LIBOR going forward. We're still getting LIBOR floors than new deals today, though they tend to be at a lower nominal rate than what we were getting a few years ago. But from an underwritten ROE perspective, we still feel very comfortable that we can, for the most part, replace what's paying off with something new that will underwrite to a similar ROE reflecting the change in LIBOR floors and also reflecting the benefit we've received over the last year or so. It's certainly been beneficial. I think roughly at a high level, close to 85% of our in-place portfolio has an active LIBOR floor today, which is to say someone is paying over and above what nominal LIBOR is. They're probably paying today at a rate that is slightly above 1 in terms of where their floor is on a weighted average basis. And I would say new deals today, you're probably putting floors more in the 25 to 50 basis points rate. So there's definitely a move there. But I think we're picking up some of that lost ROE in terms of slightly better spread to us as lender and not as significant shift in overall cost to borrower given that, obviously, rates have moved in their favor as a borrower.

So we've got a couple of minutes left here. So we'll move to our rapid-fire question. We -- when we are sitting physically together in Florida a year from today, what will be the one thing that will have surprised people the most about your business over the prior 12 months?

Great question. I think when we look back a year from now, and if we're sitting in Florida, it will definitely be with a drink in my hand while we're doing this. I think the pace of recovery in the New York condo market has caught a lot of us by surprise. I think, to your question earlier, there's clearly a very legitimate debate on urbanization and what its long-term path forward is. But if you look at how people are sort of voting with their pocket books, the transaction volume at the price level and the pacing of the resi sale market in New York has been pretty surprising over the last few months. And there's no -- at least today, there's no immediate sign of it abating.

All right. So second question. What do you think your corporate travel budget will be next year, so 2022, as a rough percentage of what you spent in 2019?

Interesting question. Look, I think the stuff that's going to fall away, right? I would say every year from 2010 through 2019, I probably took 1 or 2 red eye flights to do like 2 meetings in L.A. and then come home or 1 -- those days are long past. But I think the general travel around going to see a deal, going to see investors, I think, will pick up, and -- I don't know, if I was to pick a number, I'd say, plus or minus 75% to 80%.

And then lastly, what will the 10-year U.S. Treasury yield be 1 year from today? I think -- I don't know what it is, it's like 150 -- 154 right now.

If anybody is relying on me for this answer, they're in big trouble. Look, I think my expectation is you're going to see continued volatility, but I don't -- I think there are still reasons why inflation will stay somewhat muted. You still have a lot of people unemployed. I'd say it will still be less than 2%.

Okay. All right. Well, thank you. I think that wraps us up. But we really appreciate you attending the conference, and appreciate -- look forward to seeing you in Florida next year.

Thanks, Arren.