Yields above 10% are rarely sustained over lengthy periods of time. Mortgage trusts, which are notorious for delivering double-digit dividend rates, frequently have to reduce payouts when portfolio income falls or sector fundamentals shift abruptly.

Apollo Commercial Real Estate Finance Inc. (NYSE:ARI) now has a dividend yield of 11.3%, which is unsustainable if the commercial real estate market experiences a downturn.

A High Yield For Good Times

Without a doubt, Apollo Commercial’s hefty dividend is enticing. The commercial real estate market is witnessing strong demand for new developments, and the trust’s distributable earnings cover the generous dividend pay-out of $1.40 per share on an annually basis. However, if the U.S. economy enters a recession and portfolio income falls, Apollo Commercial’s dividend yield may be reduced further.

As an investor in commercial real estate loans, Apollo Commercial benefits from its affiliation with Apollo Global Management, a globally active investment manager with $513 billion in assets under management, strong partnerships and experience in the commercial real estate sector, and a global mortgage origination platform. The trust offers unique access to investment opportunities due to its relationships and decade-long experience in commercial real estate financing markets.

Apollo Commercial is a mortgage real estate investment trust with a sizable investment book in the commercial real estate markets of the United States and the United Kingdom. In 1Q-22, the trust held 67 commercial real estate loans totaling $8.4 billion in book value, with an average loan size of $120 million.

The trust primarily originates first mortgage loans, which are highly secured loans secured by commercial real estate such as hotels, offices, or retail properties. The loan book of Apollo Commercial consisted of 91% first mortgage loans, with subordinated loans with less investment protection (greater loss ratio) accounting for 9% of loan investments.

The most important investment categories for Apollo Commercial are offices and hotels. The trust has $2.0 billion in exposure to office markets in New York City and key European locations. Hotel mortgage loans are Apollo Commercial’s second largest investment category, accounting for $1.95 billion in value.

Because Apollo Commercial contains loans in its portfolio that are backed by commercial properties outside of the United States, the mortgage trust has some built-in diversity and may be less reliant on the United States market than strictly domestically oriented investment trusts.

In the previous seven years, Apollo Commercial has restructured its balance sheet and investment portfolio, shifting its portfolio allocation toward lower-risk first mortgage loans. First mortgage loans now account for 91% of the trust’s portfolio, up from 40% in 2015.

Subordinated loan investments have been drastically decreased from 40% to merely 9%. Commercial Mortgage-Backed Securities are no longer held by Apollo Commercial. By avoiding higher-risk investments, the trust has built a more stable investment portfolio.

Positioned For Interest Rate Growth

Apollo Commercial has positioned itself for increased interest rates by originating largely floating rate loans, which accounted for 98% of all loans at the time of the previous count. If the central bank rises interest rates, which it is doing, floating rate loans provide more interest income for mortgage trusts like Apollo Commercial.

To combat soaring inflation, the central bank raised interest rates by half a percentage point in May, and it is expected to do so again in 2022. Rising interest rates, while increasing the cost of doing business, have an offset effect on the income side by creating higher net interest income.

There Is A Reason For Apollo Commercial’s Book Value Discount

Apollo Commercial’s stock is trading at a discount to book value, but competitors Starwood Property Trust (STWD) and Blackstone Mortgage Trust (BXMT) trade at premiums to book value. This is because Starwood Property and Blackstone Mortgage did not reduce their dividends during the COVID-19 epidemic, while Apollo Commercial reduced its dividend by 24%.

The dividend coverage of Apollo Commercial is also unfavorable. The trust has paid out 100% or more of its distributable earnings in the last three quarters, implying that a dividend decrease is on the way.

Why Apollo Commercial Could See A Lower Stock Price

A correction in the commercial real estate market in the United States would be a problem for Apollo Commercial, and the trust faces the greatest risk of a dividend cut if economic growth prospects deteriorate. Despite the fact that Apollo Commercial has reallocated its portfolio and decreased risk in recent years, the trust is a higher-risk option in the mortgage trust market due to its poor dividend coverage.

My Conclusion

The stock of Apollo Commercial is cheap for a reason: if the commercial real estate sector in the United States suffers from a recession, the mortgage trust will have to reduce its dividend payout. Because of Apollo Commercial’s high pay-out ratio, the trust is likely to be the first to have to reduce its payout if the commercial real estate market cools.

Alternatives for yield-seeking investors who prioritize yield as much as dividend safety include Starwood Property Trust and Blackstone Mortgage Trust. Their yields are lower, but their dividends are far more secure.