Apollo Commercial Real Estate Finance, Inc. (ARI) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to ARI Fourth Quarter 2013 Earnings Call. [Operator Instructions] I would like to remind everyone today's call is being webcast and recorded. Please note that they are the property of Apollo Commercial Real Estate Finance Incorporated, and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this 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 our most recent filings with the SEC for important factors that could cause actual results to differ materially from these statements and projection. We do not undertake any obligation to update our forward-looking statements or projections, unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.apolloreit.com or call us at (212) 515-3200. At this time, I'd like to turn the call over to the company's Chief Executive Officer, Stuart Rothstein.

Good morning, and thank you for joining us on the Apollo Commercial Real Estate Finance Fourth Quarter and Full Year 2013 Earnings Call. Joining me this morning in New York, as usual, are Scott Weiner, our Chief Investment Officer; and Megan Gaul, our Chief Financial Officer. The commercial real estate market had a strong year in 2013, with transaction volume up and operating fundamentals throughout most asset classes showing signs of significant improvement. Over $355 billion of commercial properties were sold in 2013, a 19% gain in transaction volume from the prior year, and the Moody's/Real Capital Analytics national Commercial Property Price Index posted a 15% increase. While core properties in gateway cities showed the strongest demand, capital flows have become more evenly distributed across markets and property types. In most major markets, rents have increased and vacancies have decreased, boding well for property performance. And given the relative lack of new construction, we expect the positive trends in operating performance to continue. The commercial real estate debt market is a direct beneficiary of the increase in transaction volume, and as such, U.S. CMBS issuance totaled $86 billion in 2013, an increase of over 78% from prior year. The market has not shown signs of slowing down, and many anticipate that CMBS issuance will top $100 billion in 2014 as demand for financing remains strong. With respect to the capital markets, the volatility in interest rates continues to have minimal impact on the commercial mortgage market. Pricing on new issue CMBS remains stable, with spreads on 10-year, AAA-rated new issues at 91 basis points over swaps last week, which is 4 basis points lower than the 52-week average of swaps, plus 95 basis points. The current economic backdrop continues to be extremely positive for ARI, and as a result, the company had a solid year of operating performance. ARI delivered a 10.4% total return to our common shareholders in 2013 as compared to a negative 2.7% return for the REM [ph] mortgage REIT index and 2.5% for the RMZ [ph] U.S. REIT index. The company deployed over $420 million of equity into $525 million of commercial real estate debt investments with a weighted average internal rate of return of 13%. This was our most active year for new investments since the company went public in 2009. Our investments consisted of first mortgage loans, subordinate financings and legacy CMBS. And we were diversified across multiple geographies and property types including: Residential, office, industrial, hospitality and our first investment in the health care space. Our average loan size was $36 million, and 77% of the loans we originated in 2013 had floating interest rates. Importantly, ARI has become a significant capital partner for several of the largest global investment banks and conduit lenders and a preferred relationship for commercial real estate brokers. Our ability to originate our own investments, as opposed to buying loans in the secondary market, enables ARI to negotiate the most favorable deal structures and economics for the company. As part of the broader Apollo Commercial Real Estate debt platform, which completed over $2.5 billion of new investments in 2013, the company has developed a reputation as an innovative, reliable capital solutions provider. We also remained focused on more actively sourcing new transactions through Apollo's global platform. We completed a $47 million mezzanine transaction for a healthcare portfolio in the fourth quarter that was presented to us through a healthcare finance company acquired by an Apollo affiliate last year, and we now have an active dialogue with many borrowers in the healthcare sector. We also sourced, through Apollo, our previously announced commitment to make a $50 million investment in KBC Bank Deutschland, which is still on track for closing in the first half of 2014 pending final regulatory approval. We are very excited about this transaction, as it is expected to provide as with an attractive return as well as a gateway to the recovering European real estate lending market. Another area we have experienced success through our relationship with Apollo is our CMBS investment. Apollo, on behalf of managed accounts, is in the CMBS market on a daily basis and on occasion comes across opportunities often created by market dislocations for ARI to invest in legacy CMBS that meet the company's return parameters. In 2013, we identified one such opportunity and invested $30 million of equity into a $134 million of legacy CMBS formerly rated AAA, which have been underwritten to generate an IRR of 13%. In addition, in the fourth quarter, ARI's investment in the Hilton CMBS was repaid at par, and the company realized an IRR of 16%. Turning our attention to our portfolio. As of December 31, the amortized cost of ARI's commercial real estate debt investments totaled $849 million. The portfolio has a levered weighted average underwritten IRR of 14.1% and a weighted average duration of 3.3 years. Importantly, due to our proactive asset management, the credit quality of our loan portfolio remains stable. We are extremely proud of the progress the company made in 2013, and we believe ARI is well positioned for growth in 2014. To facilitate that growth, we're in the process of expanding our commercial real estate debt team both in New York and in London and plan to establish a dedicated CRE debt team in Europe. Yesterday, we closed an $80 million first mortgage loan, and our investment pipeline remains robust. We are looking at a wide variety of transactions both in the U.S. and internationally across varying property types as well as within different parts of the capital structure. We are confident in our ability to identify, underwrite and complete investments that continue to generate consistent returns with prior -- returns consistent with prior investments and consistent with our previously stated return targets for ARI. In growing the company, we remain focused on protecting book value, and we are continuing to explore several strategies to more effectively use leverage to fund new investments. At this point, I would like to turn the call over to Megan to review our financial performance.

Thanks, Stuart. I want to remind everyone that we have posted our supplemental financial information package on our website, which contains detailed information about the portfolio as well as ARI's financial performance. For the fourth quarter of 2013, we announced operating earnings of $14.5 million or $0.39 per share as compared to $7.4 million or $0.27 per share for the same period in 2012. Net income available to common shareholders for the fourth quarter of 2013 was $14 million or $0.37 per share as compared to $7.1 million or $0.26 per share for the same period in 2012 also. For the year ended December 31, 2013, the company reported operating earnings of $51.4 million or $1.44 per share as compared to $33 million or $1.50 per share for 2012. Net income available to common stockholders for the year ended December 31, 2013, was $45 million or $1.26 per share as compared to $37.1 million or $1.64 per share in 2012. A reconciliation of operating earnings and operating earnings per share to GAAP net income and GAAP net income per share can be found on our earnings release contained in the Investor Relations section of our website www.apolloreit.com. GAAP book value per share at December 31, 2013, was $16.18, which is unchanged from September 30. As a reminder, we do not mark our loans to market for financial statement purposes. We currently estimate that there is another $0.24 per share of value when our loans are marked to market and as such, estimate our market value per share to be $16.42 at December 31. With respect to our payments, in the first quarter, we received a total of $71 million of principal repayments from 2 mezzanine loans and the company's investment in the Hilton CMBS. In aggregate, the company realized a 14% IRR on those investments. Subsequent to quarter end, we received an additional $15 million principal repayment from another mezzanine loan, on which the company also realized a 14% IRR. We continue to operate the company with low leverage, and as of December 31, our debt-to-equity ratio was 0.4:1. Subsequent to quarter end, we amended our repurchase agreement with Wells Fargo, which we used to finance our AAA-rated CMBS for a term of 1 year and lowered the pricing to LIBOR plus 80 basis points from LIBOR plus 105. We believe our business model remains favorable in this volatile interest rate environment and are confident ARI is well positioned as interest rates rise. In addition to minimal use of leverage, 52% of our loan portfolio has floating interest rates at December 31. Finally, as indicated in our press release, the Board of Directors announced a common share dividend for the quarter ended March 31, 2014, of $0.40 per share. This is the 15th consecutive quarter of a $0.40 common dividend. Based on yesterday's closing price, ARI's stock offers an attractive 9.7% yield. And with that, we'd like to open the lines for questions. Operator?

[Operator Instructions] And our first question comes from the line of Jade Rahmani with KBW. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: Regarding your deal team comment, can you talk about the number of loan originators you currently have and where you expect that to get to? Is that really the main area in which you're looking to expand?

Certainly. It's Scott Weiner. I would say, with respect to direct origination and people focused completely on debt, it's over a dozen. But then in addition, as Stuart mentioned, the way Apollo is set up is we have no wall, and so we have a real estate equity group who we work closely with, who helps us identify deals and underwrite them, as well as a healthcare affiliate, and then just really within private equity and other parts of Apollo. It's a very integrated business model. So we have a few hundred professionals, obviously not a 100% focused on real estate. But they do come across deals and have plenty of relationships from the cofounders on down. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: And so -- and with respect to expanding the team, are you looking to hire loan originators? Or other types of people?

Yes. I think we continue to have people focused on commercial real estate debt. I mean, I think the way our business model works is that -- the way we're structured is that the people working on deals aren't just going out and meeting people and kind of handing them off. We have a model where people stay with the deal from beginning to end. We think that's the model that makes the most sense, so have a client relationship, work on the documentation and the proposals, the legal side, also work with others on the real estate underwriting side and then continue on post-closing with assisting in the asset management. We do have dedicated asset managers. We do have underwriters. But we do like our people to stay involved in the deal from beginning to end and also through post-close.

I mean, we're not using the phrase loan originators, Jade. I would say we're adding 4 people to the real estate debt deal team. So underwriting, analysis, origination, it's all focused on doing more deals in the debt space. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: And regarding leverage, can you talk about your comfort with levering the balance sheet, if you could put some parameters around that and the strategies you're exploring? I think previously, you mentioned a revolver or some type of corporate credit facility. And I'm not sure if you still look at the first mortgage portfolio as having too little duration for securitization. There's been some recent deals that have been successful, and -- from peers. So what other leverage strategies you're looking at.

Yes. I mean, I guess, taking your questions in reverse, I would say, again, given what we tend to do on the first mortgage side of things, either the duration of the more stable stuff so to speak or the stuff that we've done recently, which I would describe as properties a little bit more in transition, I would not expect a securitization from us anytime soon. That being said, we've been running the company at, call it, somewhere between 0.2 or 0.3 turns of leverage now for the better part of a year. And I think whether it is a broad corporate credit facility expanding one of our existing facilities just to provide more leverage and maybe more buckets for different types of capital, or perhaps doing something in the public markets either in term loan or convertible note fashion, I would say we're sort of in one of those good environments now, where we seem to have a lot of different options available to us. And I think for us, it's a mix between duration of capital that we want to put in place, timing of execution vis-à-vis when new capital will get invested. And also what works best given where we see likely deployment going forward. But I think everything I mentioned is in one form or another available to us, and I think the expectation would be, as needed, we'll pull the trigger on things over the next quarter or 2 to give us more capacity to invest.

Our next question comes from the line of Charles Nabhan with Wells Fargo Securities.

If I could just follow up with Jade's question regarding the debt team build-out. Now the dozen new employees, is that across Europe and the U.S.? Or is that just the U.S.?

Well, to be clear, what I was referring to is not a dozen new employees, it's really -- I would say a dozen investment professionals focused on deals. It does not include finance, legal, asset management. So it's really kind of a growth of what I would say is probably 4. We do -- we are active in Europe. We have a separate business over in Europe, Apollo that is, both on kind of the NPL side and the equity side, which we have levered. We are looking at, with the acquisition at KBC, as Stuart mentioned earlier, as well as just kind of an increase in activity over there, putting some more dedicated people on the ground. That is still a work in progress. Right now, we work, being the debt team, in conjunction with folks on the ground there. But I do think as we're seeing that business come back, both for ARI and our other buckets of capital, that we will put some dedicated people there and continue to grow.

If I could focus on that point for a second. Within Europe, do you have any particular geographic focuses right now?

With respect to kind of the performing debt business, which we've talked about ARI being, I would say it's really Western Europe, the U.K., France, Germany, Netherlands, those markets. Apollo is very active in the nonperforming business. As we have said before, we don't have that as a strategy for the REIT. We view this as a performing, fixed-income alternative view [ph] while generating current yield. I know some of our brethren have obviously done NPLs. But we're looking really pure performing loans.

And I think one of the key, hopefully, results of the investment we committed to making into the German bank is that, once that deal is complete and we begin sort of the relationship and integration with their business over time, there will be opportunities for ARI coming out of the ability to partner with a German bank that has an appropriate cost of capital to do the senior piece of a financing. And working in conjunction with ARI, you could do a sub-debt piece and provide one-stop shopping to those looking for a full debt stack.

And also -- and I would also, in addition, as I mentioned, we are [ph] asset and nonperforming business. And so while ARI would not buy a nonperforming portfolio, we certainly have been spending time using that experience and even, like, deals that we lose the bid on, looking at financing those portfolios for the winner.

Finally, if I could just have one more follow-up, could you give a sense for your liquidity position at quarter's end or maybe even at this point in the quarter following the deal you announced post 12/31? And just give us a sense for what your capacity is for future investments?

Yes, I mean [ph], given the deal we just announced as part of earnings, I think we've got about somewhere between in the neighborhood of $50 million to deploy depending on some information that we have vis-à-vis what's not been presented publicly, sort of given expected either repayments or partial repayments. So we're basically one deal away, so to speak, of having to do something. And given the pipeline, I'd refer back to my comment on leverage as sort of being the path at which we'll figure out how to continue to get capital deployed.

[Operator Instructions] And I'm showing we have a follow-up question from the line of Jade Rahmani with KBW. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: Can you quantify the earnings impact of prepayments in the quarter and also what your expectations for prepayments should be for the year?

There was -- in terms of our quarter, we had one small loan payoff roughly mid-quarter, which we sort knew was coming and got the capital redeployed quickly, so I would say the impact was pretty de minimis. I think for the year, it's a little tough to quantify the gross amount of expected prepayments because I would say there is a couple deals we currently have outstanding right now that we expect to refinance, but in many respects, we expect to be part of that refinancing and keep our position outstanding. I think in terms of pure repayments, sitting here today, you're probably looking at a number that is less than $100 million and probably closer to $50 million.

And one of our earlier condo conversion deals is nearing completion and will start selling and closing units and repaying us, we expect, kind of toward the middle of the year. That's really the only sizable one. Because obviously, there's no refinancing out of that deal. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: And with respect to the impact of prepayments, so there was no accelerated, or just recognition of yield maintenance that boosted earnings in the quarter?

No. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. And then just on the origination pace, I mean, does the last couple of quarters of originations square well with what you'd expect for 2014? Or do you think with the additional headcount, the pace of origination is likely to increase?

What I would say is, look, it's always tough to be specific on quarters, but I do think we've established a pattern over the last several of doing bigger, larger deals. So I think, certainly, some of the closings will be lumpier. I think given where we sit right now in terms of conversation on leverage and ability to boost the balance sheet a little bit, I think we feel pretty good about our ability to source the capital needed to get deals outstanding. And given the pipeline, we feel pretty good about what's achievable. So without putting, call it, a fine point on it with respect to quarters, I think given what we've done over the last, call it, year or so is indicative of where I think we can get to a new investment perspective. Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division: And just on the net lease JV. I was wondering if you could make any comments on that. And also, one of your competitors mentioned the cash profile of that business, specifically with respect to debt amortization and that being an inhibitor of the attractiveness of that business within the commercial mortgage REIT format. Can you just comment on how you view that?

Yes. I mean, 2 separate questions. I think in terms of the JV or, call it, free option that we established last year, I would say the dialogue is ongoing. I think I've sort of indicated on prior calls that just because we've got a relationship with someone, we're not just throwing capital at it. Anything sourced on that front needs to be compared with other opportunities. And I would say, given the amount of capital still chasing that lease deal, broadly right now, we still see better opportunity elsewhere in our business. Look, I think at perfect -- at certain times in the market, to the extent you can find long-term leases in the right types of assets, there is potential to generate some very attractive returns with duration that is very attractive for a vehicle like this. And I think we continue to think that over some time horizon, there might be times to get into that business. There's nothing specific to the asset class from either a depreciation or an amortization perspective that would cause us not to continue looking at the space.

Our next question comes from the line of Steve Delaney with JMP securities.

Stuart, I apologize if this has been covered. I'm bouncing between 2 calls. But I was wondering if you could comment on what your existing investment capacity is in terms of -- based on your current cash flow and capital base. And that would be a good place to start, and I have a follow-up.

Yes. I commented briefly that given the deal we announced as part of the earnings release, I think we got about $50 million left to deploy. I would tell you that given what we have in our pipeline right now, that $50 million appears to have been spoken for multiple times, though obviously, anything that we're working on in the pipeline is still subject to getting to the finish line. And as I was discussing earlier on the call, I think the path to generating the capital we need to continue investing and continue working through our pipeline is really predicated on adding a little bit more leverage to a company that is today trading at somewhere between 0.2x and 0.3x levered, so very -- no meaningful leverage. And I think the opportunities exist to think about a corporate credit facility, to think about expanding our existing facility to include different types of collateral, to looking at the public markets, either in term loan or convertible note form. Always risk of execution, but I would say, at least preliminarily based on discussions and/or term sheets that have been exchanged, each of those avenues seems like a viable source of additional capital right now. And I think the challenge for myself and Scott is really around timing capital to be brought into the company, and when capital gets invested, to minimize any earnings drag and to also be thoughtful around the duration of capital that we're adding to the balance sheet as it pertains to the duration of investments that we're making.

That's helpful. And we have previously discussed that you have, unlike some of your peers that are very focused on senior loans and leverage those 2.5x, 3x, 3.5x, you've got very little leverage, if any, on your senior loans. So that's helpful. And I do think that maybe that where -- you guys have to make this decision, but obviously, levering unencumbered assets is kind of a -- obviously, it seems to be sort of a first step without taking on undue funding risk prior to actually levering capital. But to the extent that you're looking at capital, we're seeing, I think, very nice executions on the convertible notes, and we're all benefiting from these continued low interest rates out in the 3-, 5-, 7-year part of the curve. So I appreciate that. That's helpful. And lastly, the only thing I have is, and again, apologies if you've mentioned it, but can you give us any update on the timing of your German bank transaction? It seemed like early on, last quarter's call, you were saying that regulatory approvals could take some time, almost could be like 9 to 12 months out. And I was wondering if you have an update for us there.

Yes. I mean, look, we're still thinking Q2, by the end of Q2, at least given what we're hearing from the regulators now. Both Scott and I are on regular calls with the broader deal team just to get an update both on the regulatory environment as well as the performance of the bank during this period of getting to closing. I think we -- from an operations perspective, we remain pretty encouraged from a performance perspective and feel very good about the investment that we made. I would rather not be in the business of predicting what's going to happen with German regulatory authorities. It sounds daunting when I say it, but I would say best guess today would by the end of Q2.

Well, that's helpful. It is getting closer as we move along. And is there a specific product? I mean we hear a lot about the European market and less competition because the banks are in worse shape. And so while -- what we're hearing, and I appreciate you and Scott commenting on this, is we're hearing not to necessarily assume that you're going to necessarily get higher yields, whether those are unlevered or levered, but that you might get the same yield with a better structure and a lower LTV, better covenants, that type of thing, just because it's more of a lender's market than a borrower's market. I'd just be curious if you gotten far enough along to really think about what the lending opportunities are actually going to look like relative to what you see here in the States.

Well, remember it is a bank, so the area that they will be focusing on more akin to what a Wells Fargo focuses on here in the States with their balance sheet. So a different market than what we or a Blackstone or a Starwood might focus on in terms of first mortgages. They're going to be more focused on what I would say is lower- to moderate-leverage cash-flowing assets. Europe really has never had, well, I shouldn't say never -- of late, the CMBS market unlike the U.S., has really not come back. It's always been a bank-dominated market. I would say the banks are certainly coming back. There are still some like an RBS, who announced today that they're still shrinking their book, but there are other banks who are coming back. So I would say from a senior spread perspective, it's not, as you said, going to be wildly different from the bank, I mean, the bank is going to be looking to do loans, first mortgage loans in the 2s, right, L2 [ph], something in that area. I mean, the bank business model is not predicated on senior mortgage spread being 400 or 500 over. And in real estate -- as a bank, commercial real estate, while we think it's an attractive area, will be only one part. I mean, it is going to have corporate and other businesses that a bank has. I do think the bank, which traditionally today has been focused only on Germany, under Apollo and our co-investors' ownership, the idea is to expand the bank to other markets. So for instance -- the German commercial real estate lending market is probably the most competitive market that's out there, even probably more than the U.S. But we still do see opportunities in the U.K. The bank will have the ability to invest in the U.S. at some point, we believe. And so again, it's a bank, it's not a kind of a debt fund, if you will.

Got it. No, I appreciate you clarifying that, Scott. Because I was a little off in my thinking. You're going to own equity in this bank. And obviously, if they're lending in the bank, it's going to be subject to their portfolio standards, et cetera. Is there any opportunity for, let's say, more leverage type -- working in concert with the bank. They make a first lien, restructure something as a A/B note or you come in -- that's where I was trying to go.

Yes, absolutely. Stuart mentioned that, yes. And that is one of the strategic things that we think, in addition to the investment in and of itself being what we think is a very attractive investment for ARI, we think the ability to partner ARI's desire and willingness to do more higher-leverage subordinate capital with the bank's desire to do lower leverage, lower yielding, can offer a one-stop solution to borrowers with a very attractive blended cost of funds given what the bank is looking to achieve.

And I'm not showing any further questions in the phone lines at this time. I'd like to turn the call back over to management for closing remarks.

Thank you, operator, and thank you for everybody who participated today.