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

All right. Thanks. Welcome to this session of the Citi 2022 Global Property CEO Conference. I'm Arren Cyganovich with Citi Research, and I cover consumer and specialty finance, and we're pleased to have with us, Apollo's real estate company with Stuart Rothstein, CEO. This session is for city clients only. If media and other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AB desk. For those joining us here in-person to ask management any questions, please step up to 1 of the mics, located in the center aisle of the room. If they're -- if you're joining us remotely, just simply type them into the question box on the screen, and they'll come directly to us, and we'll do our best to ask them during the session.

So what we typically do here is we start off with a fairly good question for the CEO. And Stuart, maybe you can just do a quick intro of yourself and the company? And then what are the top 3 reasons that investors should buy your stock instead of other mortgage REIT's?

Thanks, Arren. So as Arren indicated, I'm Stuart Rothstein. I'm the CEO of the vehicle. I've been with Apollo for 13 years. The vehicle was created in 2009. Today, we've got roughly an $8 billion portfolio of mostly senior mortgage loans backed by commercial real estate in the U.S. and Europe. I think from a compelling purchase perspective, we reiterated our support for the current dividend level on our last earnings call, which equates to a dividend north of 11% for a stock that is trading at a discount to its current book value, and that book value reflects reserves against those loans that we are most concerned about. And lastly, we did $3 billion plus of originations last year. We indicated a very strong first quarter expected on the origination side this year. So I think we're well positioned to continue to deploy capital and continue to cover what we think is a pretty attractive dividend in the world we live in today.

So maybe you could just start off a little bit by discussing how your CRE lending strategy differs from some of your peers because you do seem to have a little bit of a different angle than some folks?

Yes. I mean -- I think, look, broadly speaking, there are parts of our business where we all compete against each other, and then we look for points of differentiation where we can compete in the market. I would say, at a high level. Throughout our history, we've tended to be a little bit more comfortable in those situations where more is being done to the real estate for lack of a better phrase, whether that is a significant renovation of an asset, a change of use or redevelopment of an asset, a significant capital plan. We felt like if we can underwrite the real estate correctly, we're able to get paid well for taking that sort of risk, and it's worked out well for us. And then the other sort of growing point of differentiation these days is that we've been fairly active in Europe over the last few years. We have a sizable team in London based on covering opportunities in Western Europe. As an aside, Apollo as a firm has been fairly active in terms of equity -- real estate equity investing in Europe, which I think has led to opportunities as well as helped us on the underwriting side. And today, Europe represents about 40% of our book of business, which I think is highest amongst the peer group.

Maybe you could describe what you see in the CRE lending environment today? It's definitely been evolving quite a bit over the past 2 years because of the pandemic. And maybe you could, I guess, since you do have a larger proportion or a larger amount overseas as well, maybe just talk about it, U.S. versus Europe as well?

Sure. Look, I think the pandemic was in the big scheme of things, a brief moment in time with respect to real estate lending, if we -- roughly 2 years ago from today, the pandemic started. There was a 3- to 5-month hiatus in the real estate market. And by September of 2020, the real estate market has come back to sort of full-on focus on offense versus different defense at that point. If anything, it was relevant that a lot of capital was formed during the pandemic for opportunities in real estate credit. But from that point in 2020 through today, it's been a very active market in terms of real estate transaction activity in general. That level of transaction activity has created a lot of opportunities for someone in the financing business. Our perspective and it's always been a competitive business, and we're perfectly happy competing, based on relationships, reputation and the ability to get things done in the market. I would say -- and most of what I'm saying, I'd say, is let's put a little caveat to the side for what's taken place over the last 2 weeks, geopolitically. But generally speaking, on the margin, better to be a borrower than a lender these days in terms of where the capital is flowing. I think we focus as a lender on the fact that we're still sitting on record levels of capital amassed in real estate opportunity funds that are looking to buy assets, purchase assets, and that will create opportunities for us as a financier. We still see the ability to generate low double-digit ROEs, both in the U.S. and Europe, though on par. Relative basis, slightly less competitive in Europe for a handful of reasons. I would say, first and foremost, there is a less developed CMBS market in Europe, and there is really no single-asset, single-borrower CMBS market, of note, in Europe. So it creates more opportunities for folks like us on larger loans in Europe. The other thing that benefits us in Europe is that given interest rate differentials, there's actually positive economic pickup when you hedge back from Europe into U.S. dollars on the deals that we do. So again, we envision being active in both markets. I think from our perspective, there are a lot of similarities between the U.S. and Europe that make us feel comfortable in both. First and foremost, as a lender, you think about rule of law and how you protect yourself, we're very comfortable with the rule of law in Western Europe relative to the rule of law in the United States and protecting ourselves as a lender. And then once you get beyond that, the quality of sponsorship, the real estate strategies that are being implemented, the institutional liquidity in the markets as we think about exit. They work in the markets we're in, in Western Europe, the same way they work here in the U.S. So we continue to be focused on both. I think we are intrigued by what might come about in the U.S. in the short term, given that geopolitical events have certainly led to a little bit more choppiness in the CMBS market over the last 2 weeks, and that might lead to more opportunity for us on the execution side in the U.S. in the coming weeks and months.

In terms of the property types that you're pursuing these days, which property types are you favoring? And are there certain property types that you're avoiding currently?

Yes. Look, there's been clear -- some clear property types that were sort of clear pandemic winners, probably industrial more than anything else. And maybe secondarily, multifamily rentals in cities as people find themselves getting back. We certainly have always had a desire to do those sorts of deals. Obviously, we're not the only ones who think those property types are interesting. So it becomes an issue of achievable returns and finding the right situations. I think there are a couple of property types that there's at least more healthy debate around the path forward, and I would say that healthy debate creates opportunity to the extent you're willing to take a view are both, hospitality and office. Hospitality, which we we're focused on -- early on with respect to the leisure side of hospitality, the destination side of hospitality, has worked out quite well, and we've put some fund loans in the books that I feel very good about. I think it's a little harder to figure out hospitality that is at the intersection of business and tourism in cities, but we're certainly open for business and certainly trying to figure out the underwriting. I think on the office side, we've been a little bit more constructive on office than maybe some of our peers. And I think a lot of that is driven by our view that the Apollo business works better when people are back in the office. So we think long term, companies are going to make the decision that their businesses work better when people are back in the offices. I think there are certain geographies on the office side that seem to be clear winners mostly in the Sun Belt, right, whether it's Austin or Charlotte or Nashville, Miami, where clearly demographic shifts and companies trying to give people flexibility to maybe live in more lifestyle markets have worked well on the office side. I think we also are intrigued by office in some of the gateway cities, whether it's in New York or Boston, et cetera. And I think our perspective is that coming out of the pandemic, what we're seeing in our existing portfolio and in potential new deals is that the premium for newly created newly renovated space in those markets is increasing relative to commoditized or B-quality space. And I think to the extent you have confidence in a borrower/sponsor who's willing to put a lot of capital into creating more modern office space. I think there's some interesting things to do. I think where we are hesitant and where we've been hesitant even before the pandemic is on the retail side of things. I think I know the history books will probably blame the pandemic for a lot of what's going on in retail, but I think retail was going through a significant shift before the pandemic, and the pandemic has just accelerated that shift. So it's very tough for us at this point to really figure out the right way to underwrite some of the mall properties, some of the larger footprint retail properties around the U.S. and I don't see a scenario, at least today, where we can find the right balance between underwriting the risk and getting paid appropriately. We may do some things on the retail side in Europe that are a little bit more established and have a longer history and a longer track record. But I would say we're cautious on retail. We don't have a lot of appetite for new construction today, which we had in the past. And I think part of that is just wanting to see how what was delayed in the construction process during the pandemic gets absorbed. And then I think there's also legitimate debate, at least from an underwriting perspective around construction costs in light of materials inflation and labor inflation that I think we'd like to see a little bit more clarity on.

From a return environment spreads. Maybe you could talk a little bit about how they've trended versus prepandemic and today? And then are you noticing any signs yet? You mentioned the CMBS market getting a little bit out of whack recently for the geopolitical change, are you seeing any of that in terms of new deal opportunities?

It hasn't occurred of any notable amount yet. I think we're -- I think you're sort of in a little bit of a window over the last couple of weeks where people are staring at each other a little bit or we're just staring at lenders, lenders are staring at borrowers and trying to figure out where things can settle out. If you take a longer perspective and go back prepandemic to today, you're not entirely, from an ROE perspective, in that different of a space. The reality is spreads came in initially coming out of the pandemic. But now spreads are sort of -- have been flattish over the last year or so and sort of reflective of a 0 rate -- short-term rate environment. And then as -- then as the leverage we use as a company, also got cheaper over that time period. So net-net, from an ROE perspective. not terribly different. I think what has occurred over the last year or so across our firm and the sector is the LIBOR floors that we're putting in place on new loans. We're certainly lower than what exists in the book today. We've clearly been the beneficiary of those LIBOR floors over the last year or so. I think the reality is, as I look at our book today, we are probably exposed by a couple of cents on an annual basis for short-term rates that move up 50 to 75 basis points. But then once you cross that threshold, it sort of swings back in our favor again.

Okay. We've been seeing a lot of capital being raised in nonpublic vehicles recently. Have you noticed anything that's changed in terms of the market with the amount of capital that might be out there kind of looking to be deployed into new opportunities?

I'd agree with you that there's more of it. And I would say, in general, there's more nonbank capital, whether it's in mortgage REIT form or fund form. Pursuing opportunities, I would say the positive spin on that is that over the last 12 to 18 months, people are competing based on price. They're competing based on proceeds. But generally speaking, LTVs are still in the 60% to 70% range. You're not seeing some of the things we all saw during the global financial crisis where it was not uncommon to see 85% to 90% leverage levels on real estate transactions. And if it is just about competing based on using your relationships, using your reputation and battling over a few percentage points of proceeds or a little bit of spread. There's deals we'll win. There's deals we'll lose, but I'm pretty confident that we'll win more than our fair share. I think the good thing is nobody appears to be doing anything egregious with respect to structure. Nobody seems to be attempting to buy business and also a positive overall is it does appear that there's been a little bit of a slowdown in the CRE, CLO market, and all those things taken together, again, I go back to my earlier comments, better to be a borrower than a lender today, net-net, but it's a fair market in terms of competition. And I think in a fair market, we'll find more than our fair share of things to do.

Yes, and your momentum in terms of activity, you mentioned, has been really strong. You grew your commercial loan portfolio to around $7 billion, I think, from $5.5 billion, year-over-year. And I think you mentioned on your earnings call that you have about $2 billion of other commitments at the end of the quarter, or recently. What kind of growth should you expect, or will payoffs kind of mitigate some of that growth opportunity?

I mean I think, look, payoffs will impact some of that. I think it's the nature of the market, right? And as we're feeling more confident from an underwriting perspective and putting new loans in the book. It also means that those that achieve business plan have ways to finance their way out of our loans over time. That being said, again, we're shifting more and more of our portfolio to first mortgages. It's about 90% first mortgages today, 10% legacy mezz loans, and that shift will continue. I think you'll continue to see increased growth in the portfolio just based on the existing capital base, which would probably take the portfolio towards $9 billion, $10 billion of assets overall. But beyond that, that's probably where we max out after any sort of shift in leverage over time or bringing new capital into the company, which there's no plans to do at this point in time.

With the substantial amount invested outside of the U.S., in U.K. and Western Europe with all of the geopolitical issues that are happening right now, war in Ukraine. How does that impact your view of the European market?

It's a great question. Look, I think we feel very confident about what's in the portfolio today. Most of our activity in Europe has taken place over the last 12 to 18 months, which means there are new situations, a lot of fresh equity went in, in front of us. We feel very good about our price point. I think in terms of thinking about new opportunities in Europe, I think, particularly given what's going on with commodity prices and the impact of those shifts globally but most pronounced in Europe. I think we were on par, a little bit more about a potential recession in Europe than we do in the U.S. And I think that certainly impacts the way we think about underwriting new opportunities, what our downside scenarios are and need to take all those factors in as we think about opportunities. We're very -- all our exposure in Europe is Western Europe. So we don't really worry from a proximity perspective vis-a-vis the actual war, but it is the impact that war might have on the European economy. And certainly, 2 weeks in, probably more likely for a recession, certainly relative to what we were thinking 2 weeks ago, and that impacts underwriting on a go-forward basis.

Okay. Within your portfolio composition, you've had some sectors, you mentioned hotel actually performing fairly well. But it's, I think, around 24% hotel, 9% urban retail and 5% retail center. How are those underlying borrowers tracking relative to their business plans today?

On the urban retail side, we're actually seeing pretty good performance in terms of lease activity. I would say, rents are a little less than maybe what the borrowers expected, but certainly within the range of what we expected as a lender. So we're feeling pretty good about our urban retail exposure in general. And I think not that it's going to lead to a massive shift in strategy, but we also, in the first quarter, got paid off on one of our largest urban retail exposures, which was an asset in London that was ultimately bought by IKEA. And I think it just for us, reaffirm this notion that location does matter at some level, even though we all want to shop online, there are certain retail locations that work. Overall, I think, on the retail, the more non-urban retail center side of things, I think it is -- it's easy to move sideways, which is to say it's easy to sort of stay 80%, 85% occupied these days. The real challenge is what can you do to change the trajectory. And I think in that particular center, and I think you're going to see this in more big footprint, suburban retail in general, is net-net there's too much traditional retail square footage, and you're going to need to figure out ways to change the nature of some of that square footage. We're involved in a center right now in a suburban Midwest location where we're converting some of the retail square footage to office usage because there seems to be some demand for it in the market. But I think this trend of changing the nature of some of the retail square footage, figuring out how to get more density on the footprint, either by going vertical in some cases and creating more mixed-use assets or just adding more density to a site throughout parcels to create more economics is going to be more and more common in that type of retail center.

Maybe we could talk a little bit about the right side of the balance sheet. What's your primary use of -- or primary funding sources? And are there any areas you're looking to change within that side of the balance sheet?

Look, the strategy over the last few years has been pretty consistent, which is we use bank financing in the short term to create asset-specific leverage and generate appropriate ROEs. And then over time, we attempt to be an opportunistic user of the -- either term loan market, high-yield notes market or convertible notes market to create non-asset-specific leverage at attractive prices that allows us to unencumber specific assets and also term out our leverage. And I think we've done that as effectively as anybody over the last few years. We've got one near-term maturity this year, which is in August '22, maturity of about $350 million of convertible notes. I think that is the near-term focus in terms of replacing that leverage. And again, a moment in time, the convertible notes market seems to be holding in reasonably well. And I think we'll have an opportunity to replace those notes in the convertible notes market. And then there's been a lot of volatility in the high-yield market and to a lesser extent, but still somewhat volatile in the Term Loan B market. We have no need to get to those markets, but we'll always think about them opportunistically, if there's a way to term out some of our leverage.

CLO usage has really increased amongst commercial mortgage REITs over the past few years or what's your view on CLO financing?

A couple of thoughts. Much of what we do because it tends to be, for the most part, assets in a significant transition doesn't really lend itself to the CRE/CLO market. That being said, the success that others have had in that market have certainly allowed us to grind in on the economics that we get from banks on our bank facilities and then maybe in one of the more creative things we've done on the financing side, we were able to use what's done in the U.S. CRE/CLO market to convert our largest bank facility in Europe into more of a private securitization structure, which gave us a lot more flexibility, a lot more control over things than you would see in a typical bank secured lending facility. So that worked out quite well from our perspective. Our -- I think our broad perspective on the CRE/CLO market is it's hard to not remember how damaging the CRE/CLO market was to the overall market leading into the global financial crisis. That being said, I think a lot of the activity recently has been done by many of our competitors who entered this business to be balance sheet lenders and they are taking advantage of the CRE/CLO market as a moment-in-time financing tool. And I think as long as it's done in that fashion, that is perfectly acceptable and not particularly damaging to the market overall. I think we haven't seen it, but I would get concerned when you start seeing a significant number of people coming into that market who are just passing through to quickly aggregate loans, sell a senior piece and hold on to the juicy economics at the bottom, if you saw that, I'd be a little bit more concerned over the economic impact to the real estate lending sector in general.

Okay. your company ended the year at a debt-to-equity ratio of about 2.4x. Where do you think that trajectory will move going forward? And how much could that potentially help your overall returns?

Look, I think as our assets continue to shift from mezzanine loans to first mortgages, and therefore, we have more assets that we're comfortable putting asset-specific leverage on. I think you'll see the leverage level trend from 2.4x directionally towards 3x. I'm not sure if we get to 3x, but really that is just putting in the right leverage structure to match where the assets are going. It's not a change in leverage strategy. It's not a change in adding more leverage. It's just pairing the right balance sheet with where the assets are headed. But I do think over time, you'll see it head from 2.4x to the high 2s, approaching 3x.

You had mentioned before not needing to raise any equity capital currently. Is that a function of just the amount of cash that you currently have and the availability under your existing lines to increase that leverage?

Yes. I mean, look, first and foremost, as I mentioned, when we started, we're trading at a discount to book value. Right now, obviously, one cannot even think about raising equity until they are trading at a premium to book value. So we would never raise equity in a dilutive fashion. I think right now, as we look at the portfolio, we're going to be really active this year just in terms of maintaining capital efficiency across the existing portfolio. And I would say what could be more meaningful to our earnings at the end of the day, than bringing in new equity capital is actually converting some of the underperforming equity that we have in the small handful of deals that are our focused assets and converting that into a more productive use, which will have real impact on the bottom line. Okay. So look, I think as we work through our focus assets, the expectation is that success in working through problems, I think creates confidence in the market and should have a positive impact on stock price performance. I think to the extent that puts us in the advantageous position of trading north of book value. Even with that, I don't see an immediate need for equity capital, at that point, it really comes, do we think more capital changes the growth trajectory of the company. But at this point, we're pretty comfortable with the equity base we've got.

Do you have a view of why your firm is trading at a discount to book? And you just mentioned some of the actions. Are there other things that you can do to kind of turn that around?

I mean I think, look, I think the 2 primary reasons are broad concern across this sector as there was a perception that it was getting more and more competitive last year that there would be pressure on dividend level across the sector. I think from our perspective, sometimes it gets lost that we very intentionally and strategically cut the dividend twice, once at the beginning of 2019 -- at the beginning of 2020 and once in the middle of the pandemic, and that was, I think, attempting to create a dividend level that we thought was reflective of a more challenged operating environment in light of the pandemic and the notion that you might keep a little bit more liquidity in the balance sheet long term for things like another pandemic. I also think there's probably an underappreciation of the earnings drag that results from having some amount of capital that is underperforming due to challenged assets, and the sooner we're able to convert that capital to our typical 10% to 11% ROE, it flows right to the bottom line, and that's got a meaningful impact on earnings performance. And I think as a result, leaves us very comfortable with respect to where the current dividend level is, but I think that is somewhat underappreciated in the market. And then I think the other reason you trade at a discount to book value is I think there is a need for us to get to the finish line on a couple of things we've articulated in terms of a path forward on the focused assets, which I think we will do. But I think until we do it, I think people will take a somewhat cautious view.

We've seen some mortgage REITs diversify into equity property, other assets? Or do you have any interest in pursuing that as an opportunity to where you could potentially invest in something that would increase your NAV?

Sitting here today, no. We've -- look, we've looked at net lease at various times historically. I think unless we could do something in scale. There's not much of a desire just to put an odd 1 or 2 assets on the balance sheet. And given how well bid other things are, it doesn't feel like there's a real opportunity today. The other thing we've looked at historically that we have no intention of doing whatsoever is there was a point in time where we merged with a residential mortgage REIT and certainly had the ability to hold on to several billion dollars' worth of resi assets. We're not a big fan of the volatility in that space. Those who do it well should continue doing it, but I don't think that's on the horizon for us either. So we're very comfortable remaining a commercial real estate lender. We think there's continued opportunity, and we think we do it well.

Great. Just last question. Put on your prognosticator hat, where do you think the 10-year will be in 12 months from now? It's currently around, I guess, [ 20 ], I don't know [indiscernible] that?

12 months from now, I think the 10-year will be 2 plus, but less than 2.5.

Okay. All right. Well, thank you very much for joining us. Appreciate it.

Thanks, Arren.