Apollo Commercial Real Estate Finance, Inc

Ladies and gentlemen, thank you for standing by, and welcome to the third quarter 2019 Apollo Commercial Real Estate Finance Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require further assistance, please press star 0. I'd like to remind everyone that today's call and webcasts are being recorded. Please note that they are the property of Apollo Commercial Real Estate Finance Incorporated and any unauthorized broadcast form is strictly prohibited. Information about the audio replay of the 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 your most recent filings with the SEC for important factors that could cause actual results to differ materially from those 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 and are reconciled to GAAP figures in our earnings press release, which is available on an investor relations 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 the latest SEC filings, please visit our website at www.apolloreet.com or call us at 1-212-515-3200. At this time, I'd like to turn the call over to the company's Chief Executive Officer, Stuart Rothstein. Please begin, sir.

Thank you, Operator, and good morning, and thank you to those taking the time to join us this morning on the Apollo Commercial Real Estate Finance Inc. Third Quarter 2019 Earnings Call. As usual, joining me are Scott Wiener and Jay Agarwal here in New York. This past September, ARI reached its 10-year anniversary as a public company. I wanted to take a minute to highlight some milestones we have achieved over the past decade which underscore the strength of Apollo's commercial real estate debt platform. What started as a team of four people has grown to over 30 investment professionals located in New York, London, Los Angeles, and San Francisco. Since 2009, that team has deployed approximately $13 billion of capital into transactions throughout the U.S. and Europe on behalf of the company. ARI's equity market capitalization has grown from $200 million at the IPO to nearly $3 billion at September 30th, and the balance sheet is stronger and more diversified, with over $2.6 billion in repo facilities, $575 million of convertible notes, and this year's $500 million debut offering in the term loan B market. Importantly, since inception, ARI has provided shareholders an attractive yield and consistent income through its quarterly dividend, and we continue to focus daily on enhancing shareholder value. In short, we are extremely proud of ARI's performance over the past 10 years, which could not have been achieved without the incredible team of investment, asset management, finance, and legal professionals at Apollo. Turning now to Q3, ARI had another strong quarter of originations, committing capital to transactions totaling approximately $960 million and bringing originations to $2 billion for the first nine months of the year. As we discussed last quarter, we continue to find compelling opportunities to lend in Europe. Broadening our footprint, ARI recently completed its first transaction in Italy, and following the end of the quarter, we committed to two large first mortgage loans, which included a €266 million senior loan secured by a Spanish hotel portfolio, and £196 million first mortgage loan secured by a portfolio of senior care homes located across the United Kingdom. Our success in Europe continues to be a testament to Apollo's broad presence in the European real estate market and the London-based commercial real estate debt team, which has done an excellent job establishing a reputation for as a reliable, creative, and highly regarded capital provider. In addition, we continue to benefit from our ability to source low-cost financing and local currency throughout Europe. At present, we are working through several other transactions in Europe, which we expect will close prior to year-end. While our pipeline remains weighted towards Europe, we have recently completed several deals in the U.S., including two hospitality transactions in as well as a large urban retail transaction on a prime retail corner in New York City. We were made agnostic as to investing in the U.S. or Europe. As such, in evaluating transactions and culling our pipeline, there is an ongoing dialogue comparing potential opportunities in both regions and targeting those transactions we anticipate will generate the most interesting risk-adjusted returns. ARI is also benefiting from our pipeline of future fundings. During the quarter, the company funded an additional $126 million, which continues to be an effective means of keeping capital invested and offsetting loan repayments. Net loan portfolio growth for the quarter totaled approximately $670 million, and we ended the quarter with a loan portfolio totaling over $6 billion. It is worth noting some positive activity in two of our larger investments. Our condo inventory loan in the United Kingdom has been paid down through unit sales, and we expect additional pay down activity will occur prior to year end. Also, our Miami urban pre-development loan had an infusion of equity during the quarter, which reduced the size of our loan balance. Before I turn the call over to Jay, I will take a minute to discuss the $35 million of loan loss reserves we recorded during the quarter. in connection with our loan securing a lifestyle center in northern Cincinnati and our condo inventory loan in Bethesda, Maryland. With respect to the lifestyle center loan, I mentioned at the time we took the initial reserve that we were actively pursuing several value-enhancing initiatives which had somewhat binary outcomes. As those initiatives have not fully materialized, this quarter, ARI recorded an additional $32 million loan loss reserve bringing the total reserve on that investment to $47 million. The center remains at an occupancy in the low 80% range, reflecting the balance between new tenants, which are predominantly food, entertainment, or experience-related, with continued challenges in retaining traditional soft goods retailers whose business models are changing rapidly. Over the past year, the management team in the center has done a commendable job managing and optimizing costs, as well as strengthening the center's presence in and relationship with the surrounding community. We continue to view the center as being well located in a market that continues to see both business and residential growth. The next step in protecting and recovering value is to re-envision the future of the center in the face of an ever-changing retail real estate landscape. We are finalizing terms to enhance leasing by bringing in a team with more of an owner's mentality and a demonstrated track record of creativity in responding to the new paradigm of retail real estate. Finally, ARI also recorded a $3 million loan loss reserve in connection with the condo inventory loan in Bethesda, Maryland, bringing the total reserve on that investment to $10 million. At quarter end, there were seven units remaining, and the reserve taken reflects a more conservative view of timing and pricing. And with that, I will turn the call over to Jay to review our financial results.

Thank you, Stuart. For the third quarter of 2019, our operating earnings were $72.6 million, 47 cents per share. Gap net income for the quarter was 25.7 million, or 16 cents a share, which reflects the impact of the 35 million loan loss reserves Stuart mentioned. During the quarter, we closed eight loan transactions, totaling over 950 million, and funded an additional 126 million for previously closed loans. Repayments during the quarter totaled 353 million. At quarter end, our portfolio had an amortized cost of $6.1 billion, a 12% increase over last quarter. The portfolio was comprised of 74 loans with a weighted average unlevered yield of 8.2% and a remaining term of just under three years. Ninety-four percent of the loans in the portfolio had a floating interest rate. I wanted to note that effective Q4, we will account for the Lifestyle Center loan on a cost recovery basis. That is to say, all proceeds will be applied to reduce the gap-carrying value, which at quarter end was $126 million. With respect to liquidity and leverage, as of quarter end, we had approximately $540 million of available capital in the form of cash and availability on our credit lines, and we ended the quarter with a 1.3 times debt-to-equity ratio. During the quarter, we increased the credit capacity on our JP Morgan and Deutsche Bank facilities to $1.3 and $1.25 billion respectively, bringing our total repo capacity to almost $3 billion. Lastly, our book value per common share was $16.02 at quarter end, a decrease from $16.30 at June 30th. This decrease reflects both the provision for loan loss as well as $0.07 a share from the unrealized loss associated with an interest rate swap. And with that, we'd like to open the line for questions. Operator, please go ahead.

Thank you. Ladies and gentlemen, if you'd like to ask a question at this time, please press star 1 on your telephone. To withdraw your question, please press the pound key. Our first question comes from Steve Delaney of JMP Securities. Your line is open.

Good morning, everyone, and congratulations on making 10 years. Thank you. A lot of crazy things have happened in the last 10 years, and you guys are there. So, look, your press release, one of the things we noted on the face of the press release, so 960 million or so new loans, and the thing that struck me is whether they were senior loans or subordinate loans, they were all fully funded at the time of closing or shortly thereafter. So what does that tell us about these specific loans, these opportunities versus sort of the more typical bridge loan concept? Thanks.

Scott, go ahead. Yeah, I mean, I would say, I mean, look, they're clearly not construction loans. I think you've heard us in the past talking about, you know, how we're finding – you know, more and more opportunities on transitional, likely transitional. And, look, some of them are loans where, you know, there just isn't necessarily a need for a big future funding. There's not necessarily a huge amount of capital going in where we would fund that. So, I mean, you can, you know, we like, I mean, obviously future fundings are good too, but obviously we can put all our money out day one. That is even better.

Would you say that since I assume most of these are floating rates still, you know, All of them are. Yeah, they're all floating rates. So we've got historical, well, not historical low now, but we're still sub 2% on 10-year. You know, is there some reason why these properties, that owner would not want to go into a CMBS loan at this point? Are they just not optimized?

Look, I think there's a lot of reasons people might not like CMBS versus balance sheet, but there are still a lot of owners who like the prepayment flexibility, whether they think they're going to create value and might want to refinance more down the road, they might want to sell. There are people who take a portfolio approach and just obviously like floating rate debt. Look, there are plenty of people who put fixed rate debt on at 4.5% and thought they were a genius, and now they could have bought it at 3.5% or 3%. And also, look, a lot of our volume has been in Europe, whereas Europe continues to be a floating rate market. There really is not an established long-term fixed rate product there. So I think for a combination of reasons.

Yeah, points taken. The resort loan in Italy, is that made to a U.S. or U.K. sponsor, or is the borrower actually an Italian entity?

It is a local borrower.

Local in Italy.

Local in Italy. It's a family that created a resort. They've built a hotel company around it, and they still control the equity and manage the property.

Got it. Okay. And one final thing for me. On page six of your deck where you list your new loans, the $470 million loan at 5th and 57th, That's not your old 111 West 57th property, is it?

No, it's the corner of 57th Street and 5th Avenue. It's an asset in New York known as the Crown Building. We're lending on a portion of it, not the entire asset.

Got it. And when you use the term retail condominium, I kind of first scratch my head and say, are you just saying they're for sale resi condos? No. It sounds like this is actual retail store footprints that are, for whatever reason, structured in a condominium ownership.

Think of the asset as a traditional building in New York that has now been turned into multiple components, whether it be resi, hotel. As you say, street retail, we're only lending against the retail component of the asset.

Got it.

Thanks for the call.

Thank you. And our next question comes from Stephen Laws of Raymond James. Your line is open.

Hi, good morning. Good morning, Stephen. I wanted to touch base on a couple of the MES loans. I think, you know, if I look, maybe two of the five largest are on residential condo construction in Manhattan. I think there's actually a second loan attached to one of them, or at least on the same property. But can you talk about that market, what you're seeing? You know, others have been concerned, high-end condos are kind of a soft spot in Manhattan. But can you talk to your exposure there, how those business plans are going, and maybe what the attachment points are or LTV on those Mezloans?

Yeah, so look, obviously our largest Mezloan and the one that we've talked about repeatedly is on the asset Steve just referred to, which is the Steinway building or 111 West 57th Street here in Manhattan, which is the targeted highest price point sale of anything in our portfolio. Again, I think the sponsor is chipping away on the sales side. The asset is still under construction, will be completed shortly. I think what we're seeing in Manhattan today from a condo side is that there is a very healthy market for inventory loans. We were paid off on One of our larger condo meds loans, another project known as 108 Leonard, recently threw a replacement financing. So there continues to be a very healthy inventory loan financing market. I think, you know, to be candid about the New York condo market overall, things have certainly slowed in terms of pace of sales and pricing of sales. That being said, away from the Steinway building, most of what we've lent in New York, either on the senior side or through the med side, is something generally in the, call it plus or minus $1,000, a couple hundred dollars in either direction price per square foot for something that we'll sell in the, you know, call it $1,800 to $2,200 a square foot. And there is continued to be activity at those price points. And generally speaking, we're very comfortable with the portfolio across the board.

Great. Thanks for the comment there, Stuart. You know, shifting to office, any WeWork exposure or maybe, you know, to take that a step further, you know, can you talk about what you've seen since the rent control regulations have gone in and You know, any estimates on how much that's impacted valuations of those assets? I've kind of heard a fairly wide range from different people, so curious to get your thoughts on valuations of those assets in Manhattan.

Yeah, look, in terms of WeWork, there's no WeWork exposure in our portfolio, so not something that we're obviously following the story, but it doesn't have any impact on the portfolio. Scott, you can comment on rent control if you want.

Yeah, look, I think we really avoided that rent-regulated market. Obviously, always concerned about things that are tough to underwrite, legal risk being a primary one, and we've also been one where You know, when we just kind of look at cap rates and how low they are, you know, we actually struggle with, you know, kind of the resulting low debt yields that he would get. And so we're certainly not an expert on that market, which is something we never did.

Thanks. Thanks. I kind of crammed those questions together. But then lastly for Jay, kind of just into the G&A, decline sequentially I kind of found in the 10Q that, that maybe first half had a little elevated on the RSUs and also some, I guess, some one-time broken deal expenses. Is this current third quarter level more of what you expect run rate G&A to be? Do you think we'll go back into the low to mid $6.5 million on the quarterly basis or kind of any guidance on the G&A front?

Yeah, I think the non-stock-based G&A, you can think of between, call it, $8 to $8.5 million per year. There will be some noise, you know, plus or minus a few hundred thousand a quarter. But $8 to $8.5 million is a good run rate for the cash G&A.

Great. Thanks very much. I appreciate it, Jake.

Thank you. And our next question comes from Jade Romani of KBW. Your line is open.

Thanks very much. Just looking forward into, you know, the earnings trajectory of the company, you know, there's multiple factors. Thinking about anticipated repayments, which would probably be of higher-yielding loans, incremental yields, probably lower than the existing book, mixed shift to first mortgage. And then also noting that your current leverage is at, I believe, the highest level since the second quarter of 2016. And I know you've historically run the company modestly leveraged in terms of balance sheet leverage. So how should we think about those factors and the implications for the dividend in 2020? I mean, it seems stands to reason that there could be the potential for a reduction in the dividend, which would make sense given those factors. Do you agree with that?

Here's what I'd say, Jay. Look, I think from a high level, both on the asset side and on the financing or leverage side, and I'll get into a little bit more specificity, I don't think there'll be any significant change in the overall business strategy of the company, which is to say on the asset side, we continue to look for, for the most part, either senior loans or MES loans against transitional opportunities. I think the The returns are what the returns are. I don't think we are going to in any way change our view of where we want to be from an attachment point perspective, where we want to be in terms of relative to the overall value of the asset. I don't see us changing in any way our approach to the market vis-a-vis overall risk appetite. So I think, again, what is achievable on the asset side will ultimately be dictated by the market, but I have a lot of confidence in our team's ability to continue to find things that are interesting from a risk-adjusted return perspective. I think on the leverage side, I think what you're seeing in terms of the increase in leverage overall at the company is very much driven by asset mix, which is to say if you think about the goalposts of a company that is all first mortgages or a company that is all mezzanine loans, obviously As we move more from mezzanine loans to more and more first mortgages in our book, that has implications for the overall leverage, but I would say the approach to leverage strategy has not changed at all, which is to say, yes, we will continue to lever our first mortgages. We will not, as anticipated today, in any way put asset-specific financings on the mezzanine loans. but you could see a modest uptick in leverage. But I think as we think about future earnings, and look, ultimately, dividends are a result. They're not the goal. The dividends are a result of what happens by maintaining discipline on the investment side and maintaining discipline on the leverage side. There is no expectation that we will change either the investment strategy and or the leverage strategy Going forward and ultimately as we put a portfolio together and see what returns are achievable, there will be discussions with the board about what the appropriate dividend level is and those discussions will, as they've always done in the past, tend to focus on what is a sustainable long-term earning and then as a result dividend strategy as opposed to doing something that tends to bounce around on a quarterly basis.

Understood. Just pointing out the current dividend against your book value equates to an 11.5% levered return, which is after management fees and G&A. So it's quite a high hurdle to be able to hit in this market. Would you agree with that?

Yeah, look, I think what I would say is we've earned it for the first three quarters of the year. I would say based on expectations going forward, we expect to earn it for the full year. I think if you look at where we're doing new deals at, as well as what's going on competitively in the market, as well as where the overall rate environment is, I think it is certainly a challenging market in terms of overall ROEs. I think what you'll hear from us is that there's no plans and no desire to either chase risk to generate more ROE or change leverage philosophy to generate more ROE. The portfolio will generate what the portfolio generates consistent with an investment and financing philosophy similar to what we've done in the past.

And in terms of the types of transactions you're originating with the emphasis on Europe, slight mix shift toward more first mortgages, Do you view this quarter's originations and what's in the pipeline as lower risk on average than what's in the existing portfolio or comparable?

I think it's comparable from a business plan perspective. I think as we've gotten bigger, I think we've had more opportunities to step into larger senior loans or allow us to control the overall, call it credit stack. But I think if you look at the investment memos and the business plans that were articulated in what exists in the current portfolio, as well as the ten most recent investment memos and business plans that were articulated, I think you would find more similarities than differences.

With a backdrop of where we are in the cycle and our view of prices and values and cash flows, obviously we continually update our views of markets and underwriting, and obviously as does the market with valuations and things like that.

Just turning to Liberty, 7.75% cap rate seems – I thought that 6.75% cap rate in 4Q18 was highly optimistic – I candidly think the 7.75% is also optimistic. How did you come to that, and what are the risks of further write-downs? A follow-up would be, why not just foreclose on the property, sell the asset, and move on in terms of the amount of management resources, et cetera, that has to be put to work in this asset?

So I think to answer all three or four questions, look, I think from a cap rate perspective, there's a mix of quantitative and qualitative factors based on both publicly available as well as to the extent you can get your hands on them. You know, private comps for, you know, what one could hope are similarly situated assets in various markets. And then obviously the most robust source of information is the cap rates on the range of public companies that are in various parts of the retail real estate space where the market is making a commentary on call it cap rates on a daily basis and then we've got to overlay what we know of the situation in Cincinnati and come up with a cap rate that we believe is as best as possible reflective of what's going on today and that's where we ended up with the seven and three quarters. I think, you know, in terms of, you know, what may happen in the future or not happen in the future, I think, look, to the extent we believe today that we were going to take additional write-downs in the future, that would actually need to be reflected today from an accounting perspective. So we believe the reserve we took today reflects best available information and perspective on what is going on at the asset and what can be done to improve the asset. And I think to your last question, I think we believe that there is still value to be achieved or value to be recaptured through the efforts being spent on the asset, both by those here at Apollo as well as those who are working on behalf of ARI, Apollo in a consulting or other capacity. So we think there's still work to be done in order to maximize what we think the return could be for the investment.

Okay. That makes sense. On 111 West 57th, were there any additional contracts signings this quarter? And how would you evaluate the prospect for a refi of the loan?

Yeah, look, there's been nothing publicly disclosed vis-a-vis additional contracts, so nothing we can comment on. I think, look, I think earlier, I think in relation to maybe another question, there's a very healthy market for condo inventory loans today. So to the extent the asset is fully built out, which we expect it will be completed shortly and to the extent there's a decent level of initial deposit activity on units. I think there's a reasonable expectation that our capital, which is certainly not cheap capital, can be replaced in the inventory market. but there's still work to be done because it's not a simple refinancing, but certainly a receptive market for sponsorship to be approaching in terms of having those discussions.

Do you believe that you would receive a payoff at par? And in addition, I think looking at the supplemental, I believe two loans is how it's broken out, so it's about... $203 million and another $48 million, you know, just making some assumptions on what the yield could be. I believe it amounts to close to 20% of ARI's earnings. So just wondering about if you think a full payoff could be reasonable and if that quantification about earnings percentage is correct.

Yeah, I think based on the way we're carrying it, you could assume we expect to get every dollar we're owed repaid to us. So we feel very comfortable from that perspective. Jay, if you want to comment on the earnings.

Sure, yeah. This is north of a 20% blended yield, so your math is spot on there in terms of the earnings impact.

Okay. Thanks very much for taking the questions. You got it.

Thank you. As a reminder, ladies and gentlemen, that's star one to ask a question. And you may press the pound key if you want to remove. Our next question comes from Rick Shane of J.P. Morgan. Your line is open.

Thanks, guys, for taking my questions this morning. Sure. As we head into CISO implementation, not something you guys have discussed, curious how we should think about the difference between the first lien and the mezzanine or the subordinated portfolio in terms of potential reserve levels. And then I am curious from a strategic perspective, given the potential upfront costs associated with the subordinated lending, is that something, will that accounting treatment actually change your appetite for that product?

Yeah, sure. So mezzloans basically are... are kind of first mortgage loans for this purpose. So if you have a MED loan, you basically treat it as if it were a first mortgage loan to come up with the CECL reserve. And the way we think of our business going forward, this is just an accounting change, and we expect this to have no impact on how we think of future business.

And what types of allowances are you expecting to take?

We've spent a lot of time on it so far. We're not in a position to have finalized that so far. We expect to disclose this number in our fourth quarter filings, which will be sometime in February.

So the plan, Rick, is to give people a snapshot based on Q4 of what they could expect when we go live in 2020.

Okay, great. Thank you, guys.

Thanks, Rick.

Thank you. And I'm currently showing no other callers in the queue. I'd like to turn the call back over. to Mr. Stuart Rothstein for closing comments.

Operator, thank you, and thank you for those that participated this morning.

Ladies and gentlemen, thank you for your participation in today's conference. You may now disconnect. Everyone have a wonderful day.