Apollo Commercial: A Good Buy, But Monitor Closely (NYSE:ARI)

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Investment Thesis

Remember how I said mREITs are victims of the current macroeconomic environment because of rising interest rates and high inflation? Like a CEF (Closed-end fund), an mREIT is more an investment vehicle than an investment itself. An investor’s interest in the trust is extended toward its assets, and the NAV of those assets dictates the trust’s intrinsic value.

If the trust holds assets that will be detrimentally affected by rising interest rates, their value will decline and drag its share price down with them. This mostly happens when the rising short-term interest rates increase an mREIT’s interest expense more than its interest income, shrinking its net interest income (NII), leading to possible dividend cuts.

Trusts with strategies to avert an imminent threat of value depreciation through investments and diversification of assets that leverage the rising interest rate environment outperform an industry plagued with a negative investor sentiment based on fear formed out of general industry performance.

Due to a low share price, such trusts will have a high yield during strenuous environments. Since their NAV will still be high, the intrinsic value will remain intact, offering potential investors a great entry point into a trust which is likely to bounce back once the macroeconomic downturns subside.

Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) is one of those trusts.

ARI total return
Data by YCharts

ARI and Rising Interest Rates

Apollo is a mortgage REIT (real estate investment trust) that primarily invests in floating-rate mortgages secured by commercial real estate (CRE) in the U.S and the U.K. Its current portfolio has a carrying value of almost $8.4 billion, a YoY increase of 22%, with an average loan size of approximately $120 million.

ARI Portfolio Activity

ARI Investor Presentation

91% of its investments are first mortgages, with only 9% subordinate mortgages, minimizing default risks. Geographically, about 59% of its investments are in the US, including 27% in New York, with the remainder 41% in Europe, including 24% in the United Kingdom, adding diversity to the trust’s portfolio, which is usually unseen in U.S.-based mREITs.

ARI Portfolio Breakdown

ARI Website

98% of its mortgages are floating-rate mortgages which directly stand to benefit from the rising interest rates, with $1.8 billion worth of floating-rate mortgages added to its portfolio in Q1 2022 alone.

In its Q1 earnings presentation, the company showed a sensitivity analysis stipulating the effect of rising interest rates on its earnings per share.

ARI Sensitivity Analysis

ARI Investor Presentation

As can be seen above, this will positively affect the trust’s earnings, given that other factors remain unchanged. Its European holdings are already producing a net positive effect from the increasing interest rates because the current rate in the UK stands at 1% and is expected to be around 2.75% in 2023. At the same time, the current interest rate in the US stands at 1% and is projected to exceed 3% in 2023.

The higher benefit in the UK stems from the fact that the UK loans have more favorable interest rate floors than the U.S. ones. So not only is the trust benefiting from the rising interest rates but also the geographical diversity it sports in its investments.

ARI Loan Dynamics

ARI Investor Presentation

During the last interest rate hikes, which were initiated in December 2015 but started consecutive rises from November 2016 till July 2019, ARI generated a price return of almost 15% but total returns of almost 50%, outperforming the S&P 500’s 45.5%.

effective federal funds rate and apollo commercial real estate finance total return level
Data by YCharts

Distributions

Despite guiding for weaker earnings because of $726 million repayments, the company produced strong results in Q1 2022, fully covering its quarterly dividend of $0.35 per share. The trust has further guided to wholly cover its dividend throughout 2022 in its earnings call,

We believe the combination of the first quarter’s strong deployment, coupled with an active pipeline, well positions ARI to continue to generate distributable earnings that will cover the dividend for the remainder of the year.

With further first mortgage loan originations of $530 million in the UK since Q1 and expected total originations of approximately $1 billion in Q2, the trust is at the forefront of yielding maximum distributable earnings, solidifying its position in the income play arena.

With the current sustainable dividend in play, the stock yields over 11%, likely going down later in the year as the mREIT industry starts to pull out of the slump and ARI’s stock price moves upward.

ARI dividend yield
Data by YCharts

Valuation

The trust is currently trading at a discount of over 16% to its NAV per share of $15.19 and over 20% to its Book Value per share of $16.02. Based on their average and median, the stock appears to be fairly valued in terms of its P/E, P/S, P/B, and PCF.

ARI price to book value, PE ratio, PS ratio, and price to CFO per share
Data by YCharts

The recent 2.3% slide in the company’s book value stems from a $30 million write-off which is expected to be recovered in the coming quarters as the Hotel has been held for sale.

Additionally, the trust is also currently in a low credit risk environment because of two factors; a low weighted average Loan-to-Value (LTV) of 50% and lower default risk imposed by high-interest rates. These factors make the current share price an attractive buy-in point for ARI.

Conclusion

The mREIT industry is historically dragged down by high inflation and a rising interest rate environment. However, Apollo is a prime example of an entity leveraging macroeconomic factors to its benefit. The trust’s stock has been dragged down along with the whole industry, providing potential investors with an excellent entry point.

The company’s loan origination levels are high, and the expected cash flows are solid. However, the looming threat of recession is a major risk and would need to be closely monitored to avoid a meteoritic crash like the one seen in 2020.

These factors also lean me toward the probability of not expecting a dividend raise in 2022, following its historical pattern.

ARI dividend
Data by YCharts

My buy rating for the stock stems from its strong footing in the rising interest rate environment, sustainable dividends, prospects of capital appreciation, and dividend high yield.

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