Ares Commercial Real Estate Corporation (NYSE:ACRE) Q1 2023 Earnings Call Transcript

Ares Commercial Real Estate Corporation (NYSE:ACRE) Q1 2023 Earnings Call Transcript May 2, 2023

Operator: Good morning. Welcome to Ares Commercial Real Estate Corporation’s First Quarter March 31 2023 Earnings Conference Call. At this time all participants are in a listen-only mode. As a reminder, this conference being recorded on Tuesday, May 2, 2023. I would now turn the call over to John Stilmar, Managing Director and Investor Relations. Thank you, you may begin.

John Stilmar: Good morning. And thank you for joining us on today’s conference call. I’m joined today by our CEO; Bryan Donohoe, our CFO; Tae-Sik Yoon and other members of our team. In addition to our press release and the 10-Q that we filed with the SEC, we’ve posted an earnings presentation under the Investor Resources section of our website at www.arescre.com. Before we begin, I want to remind everyone that comments made during the course of this conference call and webcast as well as the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar such expressions.

These forward-looking statements are based on management’s current expectations of market conditions, and management’s judgment. These statements are not guarantees of future performance condition or results involve a number of risks and uncertainties. The company’s actual results could differ materially from those expressed in the forward-looking statements as a result of a number of factors, including those listed in its SEC filings. Ares Commercial Real Estate Corporation assumes no obligation to update any such forward looking statements. During this conference call, we will refer to certain non GAAP financial measures. We use these as measures of operating performance, and these measures should not be considered in isolation from or substitute for any measures prepared in accordance with Generally Accepted Accounting Principles.

These measures may not be comparable to like-titled measures used by other companies. Now, I’d like to turn the call over to our CEO, Bryan Donohoe, Bryan?

Bryan Donohoe: Thanks, John and good morning, everyone. Despite a challenging commercial real estate market, we continue to make constructive progress towards many of our goals and objectives during the first quarter. As we’ll detail further, we resolved a number of underperforming loans with positive outcomes reduced our exposure to the office sector, delevered our balance sheet and continued to build our cash and liquidity. In addition, we have set appropriate CECL reserve amounts taking into account current market conditions and the macro-economic outlook. During the first quarter, we further strengthened our balance sheet, lowering our net debt to equity ratio to less than two to one, and building our cash level to more than $150 million at quarter end, which represents about 20% of our shareholder equity.

Even with carrying the strong level of capital, we continue to generate ample cash flow to support our dividend, as our loan portfolio benefited from rising short-term interest rates, with a weighted average unlevered effective yield of 8.5% a 300 basis points year-over-year increase. Let’s start with our progress to-date resolving certain underperforming loans. During the first quarter, we entered into an agreement to sell two loans at attractive levels. First, we successfully sold our only five rated loan as of year-end 2022 to resolve this residential asset we discussed last quarter. This loan was sold at a small $200,000 discount to our funded balance and in line with a specific reserve we held against the loan. We also entered into an agreement to sell defaulted loan secured by an office property in the Chicago metropolitan area.

In this instance, we began foreclosure proceedings on the asset following a maturity default in January. Ultimately, we executed the sale of the note in April above our loan amount on a gross basis and after fees and expenses, fully recovered our loan at par and reduced our office exposure. We believe this outcome demonstrates the platform expertise that Ares maintains. The substantial equity cushion subordinate to our loan, as well as our active asset management enabled us to fully recover our investment despite the office headwinds. Similarly, we are actively managing our remaining four and five rated loans to seek positive outcomes. While each loan in circumstances is unique, we will explore all alternatives including loan modifications, loan sales, foreclosures, and other strategies to maximize outcomes and monetize these loans in order to redeploy our capital and capture more creative opportunities for our investors.

As many of you know, with respect to the Westchester Marriott investment, we foreclosed and took over management of the asset in 2019 ultimately resulting in a positive outcome for our shareholders. To this end, we have started the foreclosure process on one of our risk rated four loans, a defaulted $83 million multi-use senior loan collateralized by a mixed use property in Florida, where there is a likelihood that we will be taking the asset as real estate owned as early as the second quarter. In this situation, we continue to have discussions with the borrower regarding our options under the loan documents and I’ve brought in our retail specialists from the Ares team to evaluate the future opportunity available to the property. Given our view of the property and our strong capital position, we believe a compelling option to protect value is to exercise our right to take the property.

Let me walk you through a few specifics of this situation. Despite experiencing a maturity default, the property continues to exhibit stable performance underpinned by strong office occupancy from an AAA rated state government tenant with over nine years of lease term remaining. The retail space is also well occupied with some opportunity to enhance the tenancy and cash flow. Importantly, the property overall is 93% waste, and continues to generate sufficient cash flows to fully cover interest payments and we feel good about the basis. Our plans with respect to the other four and five risk rated assets will be case-by-case, but we are very focused on maximizing the outcome of these assets. And we believe we’ve taken appropriate levels of reserves against them to reflect the risk.

For example, our total CECL reserve at quarter end was $92 million, or about 4% of the portfolio at quarter end. Tae-Sik, we’ll provide more detail later in the call. Historically on our first quarter calls, we’ve provided a dividend outlook for the remainder of the year. Based on what we see today, and despite the near-term industry headwinds and credit challenges, we expect to be in a position with our run rate earnings power to continue our current level of regular and supplemental quarterly cash dividends for the remainder of the year. With that Tae-Sik, let’s walk through some of our financial highlights and further details on our portfolio and capital position.

Tae-Sik Yoon: Great, thank you, Bryan and good morning, everyone. For the first quarter of 2023, we reported a GAAP net loss of $6.4 million or $0.12 per common share. This loss was primarily due to a $21 million net increase in our CECL provision or about $0.38 per common share. Distributable earnings for the first quarter of 2023, was $15.1 million or $0.27 per common share, which included a $5.6 million or $0.10 per common share realized loss on the resolution of a previously defaulted residential loan. This loan was sold, and the loss realized in the first quarter of 2023, impacting distributable earnings. Without this $5.6 million realized loss, our distributable earnings would have been $0.37 per common share. Turning to our portfolio, we ended the quarter with a portfolio of loans held for investment, consisting of 98% senior loans, and an outstanding principal balance of $2.2 billion, which is diversified across 53 loans.

During the first quarter, we collected 99% of our contractual interest, despite having five loans on non-accrual status as of March 31, 2023. Our loan portfolio also continued to exhibit healthy trends in terms of repayments. During the first quarter, five loans fully repaid principal amounts due, which supported total repayments of $73 million, including a full repayment of a $40 million loan backed by a hotel. In terms of our other credit quality metrics, 78% of our loan portfolio at a risk rating of three or better which declined from 80% as of the fourth quarter of 2022. This change primarily reflects the negative migration and maturity default of the $83 million mixed use property loan that Bryan referenced earlier from a risk rating three to a risk rating of four.

We also downgraded one hotel and one office loan, with a total unpaid principal balance of $92 million to a risk rating five. These two loans are only risk rated five investments. Since the sponsors for each of these properties have initiated sales processes for these assets, we have established specific reserves, totaling approximately $44 million across both loans. And we have sweeping property level cash flows and both assets as potential reductions of principal. The specific reserves for these two assets include a $5.6 million reserve on a $35 million senior loan, backed by a hospitality property in Chicago metro area, and a $38.3 million reserve on a $56.9 million senior loan backed by an office property, also located in the Chicago metro area.

Inclusive of these specific reserves, we increase our overall CECL reserve by a net $21 million in the first quarter of 2023 and our total CECL reserve now stands at $92 million, or about 4.2% of our outstanding principal balance. Let me provide some further details around the components of our total reserve, which importantly, reduces our book value per common share by about $1.69 to $13.15 as of March 31, 2023. As previously mentioned, we have specific reserves of $44 million on our two five rated loans, representing 48% of the $92 million in outstanding principal balance. Of the remaining $48 million reserves, $30 million is accrued against $404 million in outstanding principal balance of risk rated four loans, which equates to approximately 7.4% of the total risk rated four loan balance.

The final $80 million of our total reserves is held against the 1.7 billion of loans, rated three or better for an average reserve ratio of about 1.1% for the loans held for investment with a risk rating of three or better. While it’s hard to look into the future, we believe our CECL reserve levels, properly takes into account current market conditions and future – macro economic outlook for our loans held for investment portfolio as of March 31, 2023. As Bryan referenced, we remain in a strong liquidity position with more than $225 million of available capital as of quarter end 2023 including $154 million in cash and further amounts available for us to draw on our working capital facility. Our net debt to equity ratio was 1.9 times at quarter end, and is amongst the lowest of our peer group, providing us additional balance sheet strength and stability.

All of ACRE’s funding sources are with leading U.S. banks and insurance companies. ACRE has no direct funding relationships with any regional banks. None of our financing is from spread based mark-to-market sources. We declared our second quarter dividend of $0.33 per share, plus a continuation of our $0.02 per share supplemental dividend that we put in place more than two years ago to share the earnings benefit of our LIBOR floors and interest rate hedges. So with that, let me turn the call back over to Bryan for some closing remarks.

Bryan Donohoe: Thank you, Tae-Sik. The road ahead will present challenges and opportunities and we believe we are well equipped to navigate this cycle. Our liquidity and capital position coupled with our experience across the sector, give us confidence that we can continue to deliver strong risk adjusted returns for our shareholders at attractive levels on the other side of this cycle. Against the backdrop of deposit instability and questions around commercial real estate concentrations in the banking system, we expect future opportunities from loan sales and maturing bank loans to provide a long runway of accretive investment opportunities. Furthermore, tighter bank lending conditions should ultimately drive a wider opportunity set for lenders like us, a phenomenon we’re seeing play out in other asset classes as well.

It will undoubtedly take some time for this to play out in the cycle and we know there will be challenges ahead. Yet we have great confidence on our experienced asset management team, and our capital and liquidity provides us the opportunity to achieve better outcomes and to play both defense and offence when the time is right. Once, we are on the other side of navigating these challenges and opportunities, we expect we will continue to be in a strong capital and financial position, to generate attractive levels of returns and dividends for our shareholders. Let me close by saying, we are deeply, deeply grateful to our investors for the trust and confidence they’ve demonstrated in Ares and their support of the company. I’d also like to thank our entire team for their hard work and dedication.

With that, I’ll ask the operator to open the line for questions.

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Q&A Session

Operator: Thank you. Our first question comes from Steve DeLaney with JMP Securities. Please proceed.

Steve DeLaney: Good morning, everyone and thanks for taking the question. We noticed you had no new loan commitments in the first quarter despite having capacity of $475 million. And I’m sure you look at that as having an opportunity costs. I’m just curious do you expect the sort of pause, and new lending to continue or are you selectively, but actively looking to make new loans? Thank you.

Bryan Donohoe: Yes, thanks for the question. I think clearly the priority has been the liquidity build, but the opportunities that we see as expanding. And so, I think while being selective, I do expect over the course of the year for us to be to be more active given the liquidity position that we’ve created. But as you’ve heard, it’s it is a pretty high bar given the macro-economic environment around us.

Steve DeLaney: Got it, okay, yes. There’s certainly not a time to reach right. You’re working – through the other things, the issues. And speaking of that, the transfer of the office loan to held for sale, I think its $27 million loan and then subsequently sold in 2Q. I’m just curious – ability to sell a troubled asset like that. Can you just generally describe what type of buyer that you found for that property and how that transaction came about? Thanks.

Bryan Donohoe: Absolutely, so it’s one that has certainly a back story, I think the equity subordination behind us in the loan allowed for a good deal of flexibility as to the overall footprint. So while the CBD assets we all hear about for conversion to residential, and the like this was an asset with more flexibility given the land that surrounded it, and we’d expected to lend itself to an alternative use and the result for us was one the correct one in terms of timing, but also successful in terms of the dollar amount.

Steve DeLaney: Right. So basically, it had development, so long-term development potential a kind of attracted sort of – an investor with a longer view. Is that the way I should think about it?

Bryan Donohoe: I think so, I think the takeaway from our perspective was just – the highest and best use for this property was not going to be office moving forward. And we expect that the buyer will initiate some movement towards that end.

Steve DeLaney: Got it. Well, thank you for the comments.

Bryan Donohoe: Thank you.

Operator: Our next question comes from Jade Rahmani with KBW. Please proceed.

Jade Rahmani: Thank you very much. I wanted to start off by asking about your portfolio mix. On Slide 4, you show other as 10%, mixed use as 9% and then I think 18% is just the cash with leverage, so that’s, hypothetical deployment. So could you just please provide some color on what the other and mixed use includes, and also, why include that senior loan investment capacity in that slide? I’m sure you’re probably not going to be making new loans until there’s a little bit more clarity in the outlook?

Tae-Sik Yoon: Sure, good morning, Jade. Thanks for your question. In terms of other – other would include things like self-storage, for example. We just felt, something is going to be less than 5% of portfolios, as sits today that we would categorize just to just to make the pie chart a little bit more easily to read. But other would include other uses like non-rent, residential and self-storage. In terms of mixed use, as the term implies, there’s more than one primary use. Generally it will include a mixture of, for example retail on the ground floor, potentially residential office on the upper floors that maybe more experiential retail involved as well. There really isn’t a neat way to categorize it just to get together there is more than one primary use for the building.