Apollo Commercial: Double-Digit Dividend Yield, But Poor Price
Established in 2009, Apollo Commercial Real Estate Finance Inc. (NYSE:ARI) is a mortgage based diversified real estate investment trust (REIT) that primarily operates in commercial first-mortgage loans, subordinate financings, commercial mortgage-backed securities, and other real estate-related debt investments. ARI’s investments in senior mortgages, mezzanine loans and other commercial real estate-related debt investments are collateralized by properties throughout the United States and Europe. As of March 31, 2022, ARI’s diversified loan portfolio had an amortized cost of $8.4 billion.
Apollo Commercial Real Estate Finance is a small-cap REIT with a market capitalization of $1.72 billion, which earns its revenue through interest on mortgage loans. Total Debt is around $6.41 billion, almost four times of its market value. However, the net worth (book value of equity investments) of this REIT is $2.25 billion, 30 percent higher than its market value. This brings down its debt to equity (D/E) ratio to 2.8. This is one of the lowest D/E ratios for a mortgage-based REIT.
Portfolio and Ownership
The subordinated loans and first-mortgage loans (91 percent of the entire portfolio) account for the vast majority of the portfolio. When it comes to property types, residential properties, and hotels account for almost 40 percent of its assets. Besides these, Apollo Commercial Real Estate Finance has investments in retail, healthcare, office, mixed-use, industrial, parking garages, caravan parks, multifamily development, and urban predevelopment.
About 27 percent of ARI’s properties are located in New York City. Among its overseas markets, the United Kingdom has the largest share of properties, that is 24 percent of ARI’s total portfolio of assets. At the same time almost a third of this REIT is owned by the big three asset management firms, namely BlackRock Inc., Vanguard Group Inc., and State Street Corporation. All together the institutional investments are around 59 percent, while the common public holds 35 percent of total equity shares of Apollo Commercial Real Estate Finance.
ARI’s price performance is extremely disappointing. Its price dropped by 9.9 percent, 5.9 percent, 13.4 percent, and 17 percent over the period of past 1 month, 3 months, 6 months, and 12 months, respectively. Not only that, Apollo Commercial Real Estate Finance is expected to witness further drop in its price as the long term simple moving averages (SMAs) are placed above the short term SMAs. The 200-day SMA (14.08), 100-day SMA (13.32), 50-day SMA (13.29), and 10-day SMA (12.23) indicate a further minor loss of price.
Over the medium and short term, the stock has performed poorly too. Prices fell by 33.5 percent, 31.7 percent, and 22.5 percent over the period of 3 years, 5 years, and 10 years, respectively. However, we need to keep in mind that if we ignore the 17 percent price loss in the past one year, the loss was very minimal over the long term. This 17 percent loss of price was driven by a 70 percent drop in net income compared to the first quarter of 2021.
Incidentally, the stock went through a major bullish run for 8 months between November 2020 and June 2021, when the stock more than doubled from $8.32 on October 29th, 2020 to $16.94 on June 16th, 2021. This happened primarily due to stock market recovery after the market crashed due to Covid-19 pandemic during the mid-March 2020. Sadly, after touching almost $17, the stock has been falling since the past 11 months. In my opinion, such a bullish run is not going to happen in the near future, purely due to the poor fundamentals of Apollo Commercial Real Estate Finance.
Drop in Earnings, and Risk Associated with It
This fall in net income is quite significant and requires further investigation. On a year-on-year (YOY) basis, total revenue from continuing operations has dropped from $72.4 million to $45.6 million, primarily due to an approximate $10 million decrease in net interest income, and creation of a $18.2 million provision for loan losses. Net interest income has come down from $71 million to $55 million, primarily due to a hike in interest expenses of $10 million.
Apollo Commercial Real Estate Finance will face difficulty in case the demand of the commercial mortgage portfolio comes down due to poor economic condition and the labor force migrating away from the CBDs. As a significant portion of ARI’s properties are located in the urban centers, there is a risk of decreased demand of mortgage loans due to people working from remote locations due to Covid-19 pandemic.
Another major reason behind the drop of net income is an almost $10 million YOY increase in cost of services. Incidentally, both interest expense and cost of services have gradually increased over the year. Thus, a YOY cost difference of $20 million was purely unavoidable, and I expect these costs to gradually increase in the coming quarters too.
The provision for loan losses once created might not be repeated only if the company is not required to write off its losses. So, even if we can avoid this loss of income in coming quarters, interest expense and cost of services will keep on increasing and will impact the net income more severely in the coming quarters, unless there is a significant plan for revenue growth.
High Dividends and its Future Sustainability
Despite all these, Apollo Commercial Real Estate Finance can be considered as an investment option purely on the basis of a consistent double digit dividend yield. The company has been paying strong and steady quarterly dividends since 2010, just after its inception. The value of quarterly dividend ranged between $0.35 and $0.46. The current yield was 10.54 percent, and the stock has recorded a four-year average yield of 11.8 percent. The year-end average yield of the past ten years is almost 10.6 percent. Banking on these exceptionally strong dividends, the company has recorded a total return of 122 percent over the past 10 years.
Moreover, unlike some of its high dividend paying peer REITs, till date, Apollo Commercial Real Estate Finance has been paying dividend mostly out of its net income (NI). Barring the post Covid price recovery period (during a few quarters) in 2020 and 2021, in almost all the quarters, the dividend per share (DPS) has been lower than its earnings in the previous quarter. There are REITs like Sabra Health Care REIT Inc. (SBRA), Omega Healthcare Investors Inc. (OHI), Healthcare Trust of America, Inc. (HTA), Ventas Inc. (VTR), and Welltower Inc. (WELL) that have paid dividends out of their capital on a consistent basis.
Though not a good practice, as WELL and VTR have a strong capital base and loan raising capability, these companies can afford to pay dividends out of capital. However, for smaller REITs like SBRA, OHI, and HTA, this strategy is not sustainable at all. I am quite skeptical that Apollo Commercial Real Estate Finance Inc. may also follow their footsteps in order to lure its investors by paying a double-digit yield in the near future. As I am skeptical about its earnings growth in the coming future, I doubt whether this REIT will be able to sustain such a high dividend without any drawing from its capital.
Hold for Income and Only with Proper Hedging
In my opinion, any risk averse investors must stay away from this stock. There is nothing available for growth seeking investors too. Only risk bearing income seeking investors can think of holding this stock till the time it is offering a double-digit dividend yield. They should forget price growth and should be prepared for price loss too. Due to these, existing shareholders must hedge their existing investments. As we have observed that this REIT was able to sustain its policy of offering double digit yield despite the price falling below $8.5, I’d buy a put option of $7.5, so as to hedge their existing exposure.
Six-month forward put options are available for an exercise date of November 18, 2022. The $7.5 put option of that date is available for a very low premium within the range of $0.05 and $0.75. I’d suggest the existing investors to buy this put option at the lowest possible premium, say within $0.2 so as to protect their investments and enjoy a pay out in the range of $0.35 and $0.5, with a double-digit yield.