Apollo Commercial Real Estate Finance: Challenges And Prospects (NYSE:ARI)

I believe the best approach to take with Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) is a cautious one, and hence recommend a hold position on the stock. I detail below the various challenges that Apollo Real Estate faces, and how this has been adversely impacting its performance. However, despite the unsustainability that is associated with its safety net, I find little to suggest ARI is a weak stock in relation to the wider mortgage REIT industry.

Company Overview

Apollo Commercial Real Estate Finance is a New York-based mortgage mREIT (mortgage real estate investment trust) that primarily deals with commercial mortgage loans and similar mortgage financing and real estate debt-based investments. The two primary dealings of the company can be divided into either senior mortgages or subordinate loans, which are collateralized by properties that vary by their type, and locations that span the U.S., UK, and Western Europe.

With a market capitalization of $1.6 billion (as of May 2022), the Apollo REIT is a small company and holds within its balance sheet a loan portfolio that has a carrying value of approximately $8.4 billion. The REIT’s portfolio diversification is presented below as follows:

Rising Interest Rate Considerations

As is the case of typical mortgage REITs, Apollo Real Estate’s fate is heavily influenced by changing conditions in the macroeconomic environment, and specifically short-term interest rates. However, what is more, critical in determining Apollo’s future potential is the degree to which it is ready to strategically adapt according to such shifts.

Looking at historical trends, it is clear that REIT performance has been remarkable in periods that were defined by gradually rising long-term interest rates, as had been seen from 1994 to late 2021. It is essential for this rise in rates to be gradual, as it allows the mREIT industry to adjust its portfolios accordingly. Typically, rising interest rates adversely impact REIT balance sheets by diminishing the value of fixed-term mortgages, as they deliver returns by older and lower interest rates. When this rise is gradual, it allows mREIT managers to gradually enhance portfolios to hold greater exposure to the higher rates of return. However, when this rise is too rapid, mortgage investors (such as Apollo) are unable to keep up with the shifts and fail to adjust their portfolios with the prevalent rates of return.

One area of strength that Apollo REIT possesses against looming uncertainties about interest rates is its portfolio, which consists primarily of floating-rate mortgages, as a result of which the entity is well-hedged against increasing rates of interest. The present climate of an interest rate climb is, in fact, certain to enhance net income per share for the REIT.

However, the sustainability of this upward trend must be considered, as rising interest rates severely reduce demand for mortgages, which could be problematic for ARI. Mortgage housing applications fell by 9% in April 2022, in only 12 months, given interest rate hikes implemented by the U.S. Federal Reserve. For this reason, I do not think a continuously rising interest curve is a cause for Apollo REIT investors to glee, as it could jeopardize the growth prospects of the company, especially if this trend continues into the long-term.

ARI achieves somewhat of a safety net through its predominantly floating-rate mortgage-based portfolio (despite the sustainability concerns I highlighted above), as well as the geographic diversity. However, it is unlikely that even geographic diversity may be a sufficient hedge against the slowly declining economic environment, given the globalized nature of these conditions.

Earnings and Performance

Taking a look at the company’s historical performance, things have not been looking great for the company, with investor returns falling for the third consecutive year. In its most recent quarterly announcement for the three months ended March 2022, Apollo brought in a total net interest income of $55.1 million, as opposed to $71.2 million in the comparable quarter of 2021, which reflected a drop of 29.2%. These revenue figures are inclusive of both the company’s operational revenue through its owned real estate assets, as well as its interest income.

Net income during this period fell by an alarming 73.9%, from $58.3 million last year, to a mere $15.2 million this year. This significant drop in quarterly figures was primarily a result of a net reversal of loan losses amounting to $18.6 million, and a foreign currency translation loss exceeding $32.5 million. This indicates that the geographic diversification that the company claims comes at a significant cost, cutting heavily at its net profit figure.

However, despite this significant shortfall in revenue, Apollo did manage to expand its portfolio value through additional funding from $7.86 billion to $8.35 billion in a single quarter. Moreover, within the quarter, the company had made commitments to new mortgage loans amounting to $1.8 billion, 100% of which were at a floating rate. As I have pointed out above, I do believe this approach may provide somewhat of a safety net when the interest increase takes place at moderate levels but could prove to be unsustainable during economic slowdowns.

Despite this apparent improvement in the portfolio, the REIT saw a fall in its book value per share post general current expected credit losses allowance and depreciation. This figure had dropped from $15.06 per share in Q1 2021 to $14.81 per share in Q1 2022. As a result, the ownership, in terms of book value, after netting of debt obligations, actually declined by almost 2%, which is not very promising, especially when investors anticipate REITs to be strong hedges against inflation, which was recorded at 9.2% in March 2022. By this metric, not only did BVPS fail to keep up with rates of inflation, but lost value over the year, which is especially alarming for the stock.

Valuation

Despite the challenges I have outlined for Apollo REIT, I find that its valuation metrics in relation to its peers demonstrate that it is the best in the mortgage REIT industry. This is useful to consider for an investor that is adamant about including stock from this sector in their portfolio. This is demonstrated in the table below:

As can be observed, in terms of forward P/E, ARI comes in with the second-lowest figure of 8.63, which indicates growth that is yet to be realized. One factor that may potentially explain this is ARI’s predominantly floating rate mortgages which hedge against devaluation through interest rate hikes. This aspect is likely to give the company an edge above its competitors and further reinforces the possibility of a potential undervaluation.

Moreover, with an impressive dividend yield at 11.27%, not only can market participants look forward to a possible rise in the stock’s price in the future (given the undervaluation this figure suggests) but also high cash returns for the investment amounts they put in. With an ROI of 2.3% and a gross margin of 61.7%, ARI certainly appears as one of the best options to consider here. It also has the lowest debt to equity ratio, further adding to its potential likeability amongst market participants.

As in the case of REITs, an especially useful metric to consider is the stock’s price to book ratio, which essentially denotes the degree to which the market has priced a stock in terms of the book value of its net assets. ARI has the second-lowest PB ratio with 0.77, trailing behind only KREF, which has 0.75. This indicates that given its price, shareholders are attributable to a higher net asset (book) value of its real estate assets in comparison to that of other companies. One deduction of this assessment is that ARI is priced significantly lower compared to most of its peers, and hence its market price is currently undervalued.

However, despite this ARI continues to hold one of the highest short rates, at 3.42%, which is a metric that cannot be ignored in this assessment. I believe this is in large part a result of the consistently declining financial results which the REIT has been delivering, as is denoted in the gross profit trends over the years of the comparative stocks:

This highlights how dwindling gross performance of ARI in recent years, has been on a steady decline. In comparison, every other comparative stock has recently been on an upward improving trend, which places ARI’s growth prospects under question. Even though ARI brings in the highest gross profit in comparison to its peers, it is the direction of this trend, since 2021, that is worrisome. Moreover, in the last four quarters since FQ2 2021, ARI has managed to beat FFO estimates only once, which was in its most recent quarter of FQ2 2022:

However, looking at the price trends of ARI along with each of its peers indicates a high correlation in movement, effectively dispelling the notion that ARI has underperformed or even overachieved in relation to the wider mortgage REIT market. This plays a significant role in contributing to my hold position toward ARI.

Macroeconomic Risks

REITs have traditionally been seen as safe investments during times of economic uncertainty, due to the perception that bricks and mortar can survive any economic crisis. However, this is far from the reality, and macroeconomic disruptions, and in particular, the potential of a recession could severely impact the financial sustainability of ARI. It is especially vulnerable to such a risk, given the predominantly commercial nature of its portfolio.

The present inflationary climate in the United States, impacted primarily by global supply chain disruptions due to the ongoing crisis in Ukraine, and economic sanctions against Russia, seems certain to be pushed towards an economic slowdown. These pressures, coupled with the fallout of the Covid-19 pandemic, add to the likelihood of adverse conditions for the real estate sector to thrive.

A reduction in economic activity and heightened interest rates may lead to a drop in new mortgages that would impact both the growth of ARI, as well as the return it can deliver for investors. Although higher interest rates would directly trigger a higher rate of return, the broader conditions that this would bring about make such a rise in income largely unsustainable for the company.

Conclusion

In many ways, ARI is not too different from any other stock in the domain of U.S. Mortgage REITs. It faces the same exposure to interest rate risks and exposure to broader macroeconomic movements in either direction. However, the company is geographically well-diversified and has a portfolio that consists primarily of free float mortgages which deliver somewhat of a safety net to the REIT, in comparison to its peers. Perhaps this is why the stock is deemed attractive and potentially undervalued by several valuation price metrics.

However, I would insist on a cautious position on the stock, as looming economic uncertainty may not be as strong protection to its financial position against its safety nets. If inflation continues to trigger interest rate hikes, and a potential economic slowdown, ARI could go down with the rest of the mortgage REIT sector. However, these fears are yet to be rationalized, and in the meantime, I recommend a hold position on ARI.