Blood In The Street! Lock In This 14% Yield Now

Co-authored with Treading Softly.

I was recently reading about how the average American believes in at least one conspiracy theory. I’m not saying that the average American is a conspiracy theorist wearing a tin hat. But the average American believes, at least in one conspiracy theory, largely because they don’t believe that their government is batting 1000 on telling the truth.

In all fairness, they usually aren’t. You do not have to look far to find a situation where the government spun the truth to try to save face, or even flat-out denied something that was later proven true. The government is run by humans, and humans frequently lie to save face rather than to tell the cold hard truth. This is one of the aspects of the human condition that every investor or person needs to be aware of when they live their life. We call people naive for blindly trusting others and believing that their intentions are always good. Yet, if you always disbelieve everyone, you’re called jaded.

A big storyline that’s been popular throughout 2022 and 2023 is the belief of a pending credit crisis. Throughout 2020 and 2021, we were blessed to have extremely-low interest rates, which led to extremely-low default rates. Strong companies readily refinanced their debt and gave themselves low fixed interest for 5 to 10-year terms. Many companies were able to refinance their debt at historically low rates and are going to be rock-stable steady.

Yet, because of this, there were next to no defaults when getting money was easy; now, default rates are starting to trend toward the historical norms or slightly peeking over them, leading many to believe that there’s going to be a widespread credit default event.

Commercial real estate is one of the sectors that is experiencing pain from higher rates. You don’t have to look very far within the commercial real estate sector to realize that commercial real estate is a tough market to be in. Office spaces are still not being used at pre-COVID levels. Since many of these mortgages are floating rate, borrowers in some cases are walking away. Deciding to surrender the property to the lender rather than pay rising interest expense.

Many lenders aren’t interested in owning properties. Often, when a lender receives a property, they look to auction it off at whatever price, even if it means realizing a large loss. Banks are major culprits of this, but not every commercial lender operates like a bank. Many commercial lenders are actually set up as real estate investment trusts (“REITs”) and are able to take over the property and operate it, or work with the creditor rather than just kick them out of the property altogether.

Today, I want to look at one opportunity in that space that I think is well worth investing in.

Let’s dive in!

One Commercial Lender To Buy Up

Apollo Commercial Real Estate Finance, Inc. (ARI), yielding 14.1%, 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.

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.

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!

Conclusion

With Apollo Commercial Real Estate Finance, Inc., we can enjoy a 14% yield from a company that is out-earning what it is paying us. While the commercial real estate sector is one that is full of pitfalls and potholes – the truth lies deeper in the story. The average investor may read a headline and fear that commercial real estate needs to be jettisoned and run away from all possible liability; the story is deeper. It’s not that just every single commercial loan and every single commercial property must be written off tomorrow. The type of loan and lending product that is being held matters significantly. Interestingly, this is true among all sorts of types of debt, yet when it comes to sectors, people will treat everything in the sector as if it’s the same. This is a fault in uneducated investors and often is preyed upon by experienced ones.

Today, you can lock down double-digit yields from a company that is operating in a sector that is not having the issues that you’re reading about in the news. What this means is that when others are spreading fear and panic, you can sit back, comfortable knowing that you are further educated and that what they are spreading is only the official story spun to scare people. Fear is a powerful motive, and instead, you can be the informed one making massive amounts of income from your holdings because you are.

When it comes to your retirement, what’s a better place to earn great income than from the market? The market continues to be the number one generator of wealth that human history has ever seen. Those who frequently lose in the market are those who frequently trade and do so using emotions instead of facts. The only emotions I want you to be feeling are the emotions that you gain from a wonderful time spent doing your hobbies or hugging your loved ones. Those emotions of happiness, relaxation, and joy – that’s what I want for every single investor and retiree. That’s something that is entirely possible with our Income Method.

That’s the beauty of our Income Method. That’s the beauty of income investing.