Apollo Commercial: A good buy, but one to watch closely (NYSE: ARI)

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Investment thesis

Remember how I said that MREITs are falling victim to the current macro environment due to rising interest rates and high inflation? Like a CEF (closed-end fund), an mREIT is more of an investment vehicle than an investment itself. That of an investor the interest in the trust is extended to its assets, and the net asset value of those assets dictates the intrinsic value of the trust.

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

Trusts with strategies to avoid an imminent threat of depreciation in value through investments and asset diversification that take advantage of rising interest rates are outperforming an industry plagued by negative investor sentiment based on fear about the general performance of the industry.

Due to the low share price, these trusts will perform well in difficult environments. Since their net asset value will still be high, the intrinsic value will remain intact, providing potential investors with an excellent entry point into a trust that is likely to rebound once macro downturns abate.

Apollo Commercial Real Estate Finance, Inc. (NYSE: ARI) is one such trust.

ARI Total Return
Data by YCharts

ARI and rising interest rates

Apollo is a mortgage REIT (real estate investment trust) that invests primarily in variable rate mortgages secured by commercial real estate (CRE) in the United States and the United Kingdom. Its current portfolio has a book value of nearly $8.4 billion, a year-over-year increase of 22%, with an average loan size of around $120 million.

ARI Wallet Activity

Presentation to ARI Investors

91% of its investments are first mortgages, with only 9% subordinated mortgages, minimizing the risk of default. Geographically, approximately 59% of its investments are in the United States, including 27% in New York, the remaining 41% in Europe, including 24% in the United Kingdom, which adds diversity to the trust’s portfolio , which is usually unseen in the United States. mREIT based.

ARI Portfolio Breakdown

ARI website

98% of its mortgages are variable rate mortgages which will directly benefit from rising interest rates, with $1.8 billion of variable rate mortgages added to its portfolio in Q1 2022 alone.

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

ARI sensitivity analysis

Presentation to ARI Investors

As can be seen above, this will have a positive impact on the earnings of the trust, given that the other factors remain unchanged. His European holdings are already producing a net positive effect from rising interest rates, as the current rate in the UK is 1% and is expected to be around 2.75% in 2023. At the same time, the rate interest rate in the United States remains at 1% and is expected to exceed 3% in 2023.

The highest advantage in the UK stems from the fact that UK loans have more favorable interest rate floors than those in the US. Thus, not only does the trust benefit from the rise in interest rates, but also from the geographic diversity it displays in its investments.

Dynamics of ARI loans

Presentation to ARI Investors

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

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

Distributions

Despite lower earnings guidance due to refunds of $726 million, the company delivered strong results in the first quarter of 2022, fully covering its quarterly dividend of $0.35 per share. The trust further decided to fully hedge its dividend throughout 2022 in its earnings call,

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

With new UK first mortgages of $530 million since Q1 and expected total loans of around $1 billion in Q2, the trust is at the forefront of generating maximum distributable profits, strengthening its position in the income gaming arena.

With the current sustainable dividend in play, the stock is yielding over 11%, likely declining later in the year as the mREIT industry begins to emerge from the slump and ARI’s stock price rises .

ARI dividend yield
Data by YCharts

Evaluation

The trust is currently trading at a discount of more than 16% to its net asset value per share of $15.19 and more than 20% to its book value per share of $16.02. Based on their mean and median, the stock appears to be correctly rated in terms of 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% decline in the company’s book value stems from a $30 million write-off that is expected to be recovered over the next few quarters as the hotel is held for sale.

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

Conclusion

The MREIT sector has historically been dragged down by high inflation and a rising interest rate environment. However, Apollo is a prime example of an entity leveraging macro factors to its advantage. Shares of the trust have been dragged lower along with the broader sector, providing potential investors with a great entry point.

The company’s loan origination levels are high and expected cash flows are strong. However, the looming threat of recession is a major risk and should be watched closely to avoid a meteor crash like the one seen in 2020.

These factors also make me lean towards the likelihood of not expecting a dividend increase in 2022, following its historical pattern.

ARI dividend
Data by YCharts

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

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