Apollo Commercial Real Estate Finance: 12.5% Dividend Yield, But Dividend Appears Unsustainable (NYSE:ARI)
Apollo Commercial Real Estate Finance (NYSE: ARI), a REIT that invests in diversified mortgages and other real estate-backed loans, currently offers a high dividend yield of 12.5%. However, the dividend payout does not appear sustainable due to ARI’s profit outlook. The REIT’s earnings are expected to remain stable for the next year versus Q3 2020 as the decline in office real estate is likely to offset the recovery in other segments, including retail and hotels. The dividend payment was already uncomfortably high in the third quarter; Hence, it is likely that the REIT will opt for a dividend cut next year. I expect ARI to cut its quarterly dividend by $ 0.05 per share to $ 0.30 per share, suggesting a high dividend yield of 10.8%. The forward dividend yield and the potential uptrend combine to give a high total expected return. However, ARI carries a moderately high risk due to its exposure to office real estate. In my opinion, the expected total return is not high enough to offset the increased risk. Therefore I assume a neutral rating for ARI.
The result for next year should stabilize at the level of the third quarter
ARI’s earnings per share decreased from $ 0.36 per share in the second quarter of 2020 to $ 0.31 per share in the third quarter. I expect ARI’s earnings to remain stable versus third-quarter earnings over the coming quarters, which will put pressure on the dividend payout.
As mentioned on the third quarter conference call, loan changes during the pandemic hurt ARI’s overall portfolio return. I expect some improvement in returns over the coming quarters as the retail and healthcare sectors are expected to rebound in the first half of 2021 as vaccination against COVID-19 spreads. The retail and healthcare sectors accounted for 16% of total credit at the end of the last quarter, as noted in the third quarter investor presentation. In addition, hotels, which accounted for 24% of total loans, are expected to bounce back in the final quarter of 2021 once life returns to normal and people go back to leisure. Also, I expect ARI’s UK fortune to rebound ahead of its US fortune as the UK has a head start in the vaccination process, according to news reports. Loans in the UK accounted for 18% of ARI’s total loans as of the end of the last quarter, as noted in the presentation.
On the flip side, office loans are likely to continue to weigh on net interest income after the pandemic ends. Office real estate was the largest segment in ARI’s loan portfolio as it accounted for 28% of total loans, according to the presentation. The long-term move to a work-from-home (“WFH”) culture is likely to affect growth prospects in this segment. According to a poll by the Pew Research Center, cited in a Bloomberg news report, more than half of U.S. employees currently working from home say they want to keep their long-distance brokerage agreements beyond the pandemic. However, I am not overly concerned as ARI does not have any equity on its projects. Instead of a direct equity stake, ARI invests in mortgages and debt securities, which typically have a senior equity interest.
With the above factors in mind, I expect ARI to post average quarterly net interest income of $ 69 million in 2021, almost unchanged from Q3 2020.
ARI took excessive risk provisioning in the first quarter due to the pandemic. The REIT then reversed part of the reserve construction in the second and third quarters. I don’t expect any further major reversals in the final quarter of 2020 and provisions normalization in 2021. Also, I expect operating costs to grow normally 3% year over year in 2021. Given my outlook for net interest income, provisions, and operating expenses, I expect ARI to post earnings of $ 1.23 per share and operating profit of $ 1.33 per share in 2021. The following table shows my estimates of the income statement.
Dividend cut seems likely
The current dividend level suggests a dividend yield of 12.5% based on the closing price on December 10, 2020. If ARI keeps its quarterly dividend at its current level of $ 0.35 per share, it will have to carry an awkward payout ratio over 100%. The table below shows the payout ratio if ARI maintains its quarterly dividend.
Given the high payout ratio shown above, I expect ARI to cut its quarterly dividend by around $ 0.05 per share over the next year. The REIT previously cut its quarterly dividend by the same amount in the second quarter of 2020, which is $ 0.05 per share. I don’t expect ARI to cut more than $ 0.07 per share as REITs have to pay more than 90% of their taxable income. My estimated quarterly dividend of $ 0.30 per share suggests a dividend yield of 10.8% for 2021.
High expected total return with moderately high risk
Given my earnings and dividend estimates, I expect ARI’s book value per share to increase from $ 15.0 per share at the end of September 2020 to $ 15.9 per share by the end of 2021. To evaluate ARI, I’ll multiply the forecasted book value per share by an average price-to-book ratio (“P / B”) of 0.7 for the first nine months of 2020. The graph below shows the trend in the P / B multiplier this year.
Data from YCharts
Multiplying the average P / E by the forecast book value per share results in a target price of USD 11.1 for the end of next year. This price target implies a downward trend of 0.5% compared to the closing price on December 10th. The following table shows the sensitivity of the target price to the PER.
Since ARI is a mortgage REIT, the value for money can also be used to aid the valuation analysis given above. ARI has been trading at an average price / quality ratio of 10.52x since 2015, as shown below.
Multiplying the above average ratio by the projected earnings per share for 2021 results in a target price of $ 13.0, which is an upward movement of 16.2% from the closing price on December 10th. The following table shows the sensitivity of the target price to the price-performance ratio.
In my opinion, both valuation methods should be weighted equally in order to determine ARI’s final price target for the end of next year. Therefore, my combined price target is $ 12.0, which is an upward trend of 7.9% from the December 10th closing price. The following table shows the target prices with different weightings for the two valuation methods.
The potential upward trend in price of 7.9% and the forward dividend yield of 10.8% give an expected total return of 18.6% for the next year. While some risk tolerant investors find this return attractive, I’m cautious about the REIT because of its exposure to office real estate. I would ask for a higher rate of return to offset the moderately high risk of ARI. As a result, I am assuming a neutral rating for the REIT.
Disclosure: I / we have no positions in the stocks mentioned and no plans to open positions within the next 72 hours. I wrote this article myself and it expresses my own opinion. I don’t get any compensation for this (except from Seeking Alpha). I do not have a business relationship with any company whose stocks are mentioned in this article.
Additional disclosure: Disclaimer: This article is not intended to provide financial advice. Investors are expected to consider their investment objectives and restrictions before investing in the stocks identified in the article.