Co-authored by Treading Softly.
“A smooth sea never made a skilled sailor.”
– Franklin D Roosevelt.
When everything is smooth, the ocean is calm, the wind is fair, and the weather is bright, it’s easy to think you understand what it means to be a sailor. However, it isn’t until the storms come, the wind howls, and the sea is tumultuous that a sailor can transition from being a novice to being skilled. This is because your skills are not truly tested until you face a challenge.
In a bull market, when everything is climbing, every single analyst, researcher, or investor appears highly skilled because they can see success readily and easily. It isn’t until a sector, the market, or the economy hits speed bumps and sees tumultuous times that an investor gains experience. Certainly, it can be easy to put more money into the market when it is on its upward trajectory, and it can be even easier to lock in long-term losses and capitulate to failure when the market is struggling. It is those investors who continue to invest in the markets, growing their portfolios and standing firm on their convictions that become experienced and skilled over the long run.
Today, I want to examine a specific company in this sector that is experiencing tumultuous seas. In recent quarters, this sector has seen several dividend cuts. Book values are falling, and companies are taking different courses of action to try to weather the storm. This company, however, is plotting its path and is experiencing success thus far.
Let’s dive in!
Keeping Their Hand On The Plow
In what has been a very tough quarter for commercial mortgage REITs, Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI), yielding 13.5%, reported a relatively strong quarter. Distributable Earnings remained flat at $0.35, and book value drifted down $0.02 to $13.20 after all CECL (current expected credit loss) reserves. It actually drifted up $0.03 to $13.62 before general CECL. Source.
With other lending companies, we have discussed the negative impact on cash flow from failing to redeploy capital. In many ways, the story of Q2 2024 is that mortgage REITs and BDCs that were able to grow their portfolios did relatively well. Those who didn’t grow had tougher quarters and saw cash flow decline. ARI grew its portfolio by only $8 million, but that was enough to provide stable earnings.
ARI bought back $38 million in stock in Q2. Because of its larger size, it was comfortable buying back equity at a price so far below book value.
Looking forward, the overall tone of earnings calls throughout the sector has become much more optimistic about lending opportunities to grow their portfolios and that the bottom of credit issues is in. However, there are still some lingering risks and ARI disclosed that they expect to recognize a CECL impairment in Q3 or Q4 for a loan they hold secured by the Steward Properties. Management was unwilling to discuss the situation in depth beyond what had already been disclosed in Steward’s bankruptcy proceedings. Some properties might be sold, and some ARI might take possession of. They indicated they expect the impairment to be $90 million, or approximately $0.65/share. So we can pencil that number in, but management noted the situation is still fluid.
It has been a very tough environment for commercial mortgage REITs. Historically, rising interest rates have been favorable for them, but the negative pressures in the real estate sector have overwhelmed the benefit of higher rates. Today, they can’t wait for rates to get cut so that the real estate market starts buying and selling again to provide these REITs with opportunities to lend. While it appears the bottom might be in, we need to keep in mind that recovery isn’t always going to be in a straight line. We could have another tough quarter or two before these companies can really get aggressive and start rebuilding the capital lost during this rough period.
Conclusion
Apollo Commercial Real Estate Finance, Inc. has been demonstrating what it means to keep your hand on the plow and remain focused on doing what you need to get done. While other commercial mREITs are staying on the sidelines, deciding not to take action and remaining conservative, waiting for better weather, ARI is out in the field. It is getting what has to get done to continue to reward shareholders as effectively as possible. While I respect and understand both approaches and maintain healthy allocations to holdings that have taken both these approaches, I am enjoying steady dividends from ARI.
This is one reason why we encourage investors to hold at least 42 unique income investments, a.k.a. our Rule of 42. It allows you to diversify across various holdings, each managed by different teams with distinct strategies, ensuring benefits across diverse market conditions. Today, the commercial mREIT sector is in rough seas while other sectors in the market have clear, open skies and lots of income pouring in. By maintaining a diversified portfolio, I am in a position to collect income regardless of what is happening in the market.
When it comes to your retirement, income is a must. I recommend that you cast that net as wide as you can, not relying on just one or two holdings to be able to generate the income that you need. When the waves are crashing, and other ships around are struggling, having a vessel that consistently provides income, guided by skilled sailors, offers much-needed peace of mind for a retirement marked by abundance and enjoyment. That’s the beauty of my Income Method. That’s the beauty of income investing.
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