Pick #3: ARI – Yield 13.5%
Apollo Commercial Real Estate Finance (ARI) is a commercial mortgage REIT. ARI makes mortgages on commercial office properties, which it then holds and collects interest until it is paid off at maturity. Unlike many other mortgage originators, which generate the mortgage and then promptly sell it to someone else, ARI originates its own mortgages and holds them to maturity.
As a result, ARI gets all the economic benefits of making quality mortgages that are paid as agreed. It also carries the downside if a mortgage isn't paid off. In the news, you've probably heard a lot about, this or that commercial building defaulting on its mortgage. You don't have to look hard; a casual Google search will bring up headlines like this one:
Shorenstein Properties Defaults on $350M CMBS Loan Tied to 1407 Broadway
Headlines, which then lead many investors to search their portfolio for anything related to commercial real estate and click sell. This headline noted that it was a "CMBS" loan. That means "collateralized mortgage-backed security". CMBS loans are loans that are sold to investors in pieces. The originator of the mortgage might retain a very small piece but doesn't have a lot of skin in the game. The "servicer" is a company that is in charge of collecting the payment. The servicer collects a percentage of all payments made but doesn't actually own any of the loan. So when a CMBS defaults, the property is foreclosed on by the servicer and auctioned off ASAP. The parties involved in deciding to auction off the property have the least amount of skin in the game. The ones who realize the largest losses are the investors who bought the CMBS. This is why CMBS loans are notoriously difficult for borrowers to negotiate with the lender. The servicer simply doesn't care, and if a loan is "bad", it would rather get it off the books quickly and put efforts towards servicing a paying mortgage. The originator is writing off a small loss, and unless there are a lot of them, doesn't really have much incentive to learn from any underwriting mistakes. The investors with the most to lose, have no power to decide what happens.
Compare this structure to ARI, which is the originator, the servicer, and the primary investor all in one. ARI has a lot of incentive to have quality originations because poor underwriting will impact ARI directly. It has a lot of incentive to work with troubled borrowers to try to find a solution that is profitable for all parties. And if a solution can't be reached, ARI doesn't auction off the property for a poor price. It takes possession of the property and has the option to hold it until it can be sold at a fair price.
As a result, when a borrower defaults, ARI has the incentive to maximize the returns in a way that CMBS originators and servicers don't. It is a reality of lending that some borrowers won't pay as agreed. It is unavoidable, even with the highest quality of underwriting. Yet if the underwriting of a commercial property was good, then the odds are that the real estate is still valuable even when a borrower defaults. ARI has foreclosed on a few properties this year as borrowers struggled with rising interest rates. These properties are profitable to the tune of $7 million last quarter after depreciation expense. Source
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ARI Q2 2023 10-Q
If we exclude depreciation expense, which we would do for any equity REIT as a matter of course, the properties that ARI foreclosed on produced $9.2 million in positive cash flow last quarter.
The market sees "default", and they panic. And if you are a CMBS investor, there is good reason to panic because if the borrower defaults, your recovery is going to be poor. However, for ARI, it is a turbulence that they can overcome. These foreclosed properties are cash flow positive, and it is entirely possible that down the road, ARI can sell the properties at an amount that meets or even exceeds the original loan on the property.
There is an old saying, "follow the money", which really means look for who profits, to understand what is happening. When you follow the money in CMBS, it isn't hard to understand why they are so quick to default and so quick to be auctioned off. The interests of the originator and servicers are poorly aligned with the investors. With commercial mortgage REITs, the money is all flowing or not flowing to the REIT. Whether the loan is just originated, being paid off, distressed, or foreclosed on, it is the REIT that is experiencing the financial gain or loss. So when a borrower can't make payments, a REIT like ARI is able and willing to work with the borrower to reach a profitable deal. If one can't be reached, ARI can take the property, getting it unencumbered at a price of 35-50% off the price the last owner paid. Being unencumbered from a mortgage is often enough to make a property that is losing money into one that has positive cash flow.
This is why, despite a few defaults this year, ARI posted $0.46 in distributable earnings, covering its dividend by 130% in Q2. For the past four quarters, ARI has covered its dividend by approximately 130%. Source
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ARI Q2 2023 Supplement
ARI is easily covering its dividend, and with interest rates staying higher for longer, earnings should remain high since most of these mortgages are floating-rate.
Book value is $14.47, and today, you can pick up shares in the market for a lot less, providing a lot of cushion if more borrowers do default. It is a tough market for commercial real estate, but when you follow the money, you'll find that it is flowing through ARI!
