Ares Commercial Real Estate Corporation (NYSE:ACRE) Q3 2023 Earnings Call Transcript

Ares Commercial Real Estate Corporation (NYSE:ACRE) Q3 2023 Earnings Call Transcript November 3, 2023

Ares Commercial Real Estate Corporation beats earnings expectations. Reported EPS is $0.25, expectations were $0.23.

Operator: Good morning. Welcome to Ares Commercial Real Estate Corporation’s Third Quarter September 30, 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Friday, November 3, 2023. I will now turn the call over to your host, Mr. John Stilmar, Managing Director of Investor Relations. Thank you. You may begin.

John Stilmar: Good morning, everyone, 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 the management 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 and 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 anticipate, believe, expects, intends, will, should, 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 and 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 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 measures of operating performance, and these measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles.

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

Bryan Donohoe: Thanks, and good morning, everyone. During the third quarter, we continued to execute on three primary goals we have discussed previously. First, we intended to maintain strong levels of liquidity and moderate leverage. Secondly, we wanted to take advantage of the lending market and our liability structure to selectively originate new loans that would be accretive to our earnings. And finally, we wanted to continue to maximize the value of our underperforming assets. In general, we are pleased with the progress we have made executing against these goals. With respect to the portfolio, we experienced general stability in credit performance as our level of defaults and the universe of risk rated 4 and 5 loans modestly declined quarter-over-quarter.

While the benefit of today’s rate environment has served to enhance our net interest income, the impact of the higher for longer interest rate environment has resulted in greater economic uncertainty and further headwinds to commercial real estate values. This higher cost of capital is also leading to dramatic reductions in new construction, which we ultimately believe will result in favorable supply dynamics and drive support for commercial real estate fundamentals and values in the future. Specific to ACRE, we believe our deliberate approach of operating with moderate leverage while still generating attractive earnings is the best strategy for navigating today’s market. We believe the strength of our balance sheet and capabilities of the broader Ares platform gives us a distinct advantage in addressing our underperforming investments as well as selectively investing in today’s attractive lending market.

Now let me spend some time discussing some of the actions we took this quarter and our approach in maximizing value of our underperforming loans. This quarter, we foreclosed on the $83 million loan collateralized by a mixed-use facility located in Florida. This loan is now held as REO on our balance sheet. As a reminder, this is an office and retail mixed-use property in Tallahassee that is over 90% leased and continues to generate cash flow that is roughly equivalent to the interest income we earned as a loan. 100% of the office space is leased to a AAA-rated tenant that has approximately a nine-year weighted average lease term remaining. The retail space is also well leased with approximately 85% occupancy and a weighted average term of about seven years.

This is where we, at Ares, will continue to actively manage the property with the aim of pushing retail occupancy even higher. It’s important to point out that we did not recognize an impairment when foreclosing on the property and currently hold the property unlevered. As one of the leading value add and opportunistic real estate managers, the capabilities at Ares support our ability to own and execute this business plan. Given our balance sheet position, strong operational capabilities and the cash flow profile of the property, we are optimistic about the long-term value of this asset. We also exited a $35 million hospitality loan through a discounted loan payoff this quarter. Given the volatile cash flow profile of this property, the capital required to complete the business plan as well as our view of the future value, we believe it was in ACRE’s best interest to exit the loan and redeploy this capital into higher-earning investments.

As both of these loans illustrate, our platform capabilities and balance sheet position allow us to take unique strategies to each asset with the goal of maximizing value. Our balance sheet position also allows us to opportunistically invest in today’s market. We remain focused on financing strong performing property classes with secular demand drivers, such as industrial, multifamily and self-storage. For example, this past quarter, we originated a $58 million senior loan backed by a newly built Class A multifamily property located in Cincinnati, Ohio that is 95% leased. This property is well located in an affluent part of the city with compelling local supply and demand dynamics. We financed this property at historically lower levels of loan-to-value, modestly wider spreads and reset property valuations.

Looking forward into the fourth quarter and year-end, we expect to make further progress on reducing our exposure to office loans. Through a combination of principal paydowns and exits, we are targeting more than $70 million in outstanding principal balance of office loans to be cleared out in the fourth quarter, but that may well extend into the first quarter of next 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: Thank you, Bryan, and good morning, everyone. For the third quarter of 2023, we reported GAAP net income of $9.2 million or $0.17 per common share. Our GAAP net income was impacted by a $3.2 million net increase in our CECL provision or about $0.06 per common share. Distributable earnings for the third quarter of 2023 was $13.5 million or $0.25 per common share, which was impacted by the $4.9 million or $0.09 per common share realized loss on the defaulted hospitality loan that was resolved in the third quarter. Turning to our portfolio. We ended the quarter with a diversified portfolio of 49 loans held for investment with an outstanding principal balance of $2.2 billion, 98% of which were senior loans. During the third quarter, we received $48 million of total loan repayments, including $25 million of proceeds from the hospitality loan as well as loans backed by self-storage and industrial properties that were repaid at par.

In terms of credit quality metrics, 78% of our loan portfolio had a risk rating of 3 or better, which improved from 74% in the second quarter. The improvement was driven by the reduction of our risk rated 4 and 5 rated loans as two such loans were either resolved or converted to REO. During the third quarter, no new loans originated from a risk rating 3 to a risk rating of 4 or 5 in the quarter. We did downgrade one office loan from a 4 to a 5 risk rating with a total unpaid principal balance of $33 million and established a specific reserve of $14.4 million. Inclusive of this specific reserve, we increased our overall CECL reserve by net $3.2 million in the third quarter of 2023. Our total CECL reserve now stands at $116 million or about 5.25% of our outstanding principal balance.

Let me provide some further details around the components of our $116 million CECL reserve, which equates to $2.14 per common share total reserve and impacted our book value per common share of $12.62 as of September 30, 2023. As previously mentioned, we have specific reserves of $55 million, representing 61% of the $90 million in outstanding principal balance on the two risk rated five loans. Of the remaining $61 million of reserves, $46 million is accrued against $388 million in outstanding principal balance of risk rated 4 loans, which equates to approximately 12% of the total risk rated 4 loan balance and compares to 10% in the quarter prior. The final $15 million of our total reserve is held against the $1.7 billion of loans rated 3 or better for an average reserve ratio of about 86 basis points of loans held for investment with a risk rating of 3 or better.

While the market remains challenged, we believe that our CECL reserve level appropriately takes into account current market conditions and the macroeconomic outlook for our loans held for investment as of September 30, 2023. With respect to the $57 million office loan that is risk rated 5, we continue to be on target to resolve this property, which will result in approximately a $41 million realized loss in the fourth quarter of 2023 or possibly first quarter of 2024. As Bryan referenced earlier, we maintained significant liquidity and moderate net debt-to-equity ratio of 2.0 at quarter end. At quarter end, we had over $130 million in cash and amounts available for us to draw under our working capital facility. In addition, we are holding our REO unlevered, which we believe can be financed to further increase our liquidity.

Finally, we declared our fourth quarter dividend of $0.33 per share. So with that, let me turn the call back over to Bryan for some closing remarks.

Bryan Donohoe: Thank you, Tae-Sik. While a higher for longer rate environment will extend this cycle and will likely present unforeseen challenges, we believe it will also present some highly attractive investment opportunities. Our moderate leverage and healthy level of liquidity positions us well to navigate these dynamics and ultimately deliver attractive shareholder returns. As always, we appreciate you joining our call today, and we’d be happy to open the line for questions. Operator, could you please open up the line?

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Q&A Session

Operator: Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Sarah Barcomb with BTIG. Please proceed with your question.

Sarah Barcomb: Hey, everyone. Thanks for taking the question. So you mentioned in the prepared remarks that you’re targeting about $70 million of office principal to be cleared out between Q4 and Q1. And it sounds like that includes the 5 rated Chicago office loan. Does the balance of that include a potential resolution on the California office loan pr is that mostly in the 1 to 3 rated book? And will those result from more asset sales or refinancings or how should we think about that?

Tae-Sik Yoon: Yeah. Good morning, Sarah. Thank you very much for your question. Yes, the $70 million does include the Chicago office loan that we mentioned we are targeting for resolution in the fourth quarter. Again, that may slip into the first quarter. But right now, we believe it is on target for fourth quarter. And then the other amount is made up of an office loan in California, as you said.

Sarah Barcomb: Okay. Great. And then I was hoping you could talk about your outlook for net portfolio growth over the next few quarters. We saw the portfolio contract a bit due to the foreclosure in the loan sales, but new fundings actually, it looks like outpaced regular way repayments. So I’m just curious for any thoughts on your outlook for continuing to make new investments and how we should think about that net growth. Thank you.

Bryan Donohoe: Yeah. It’s a good question, Sarah. I think tough to determine exactly what the cadence will be. As we said in the prepared remarks, we do see, and I think you’re seeing us across the industry a good set of opportunities. But it’s a little less rhythmic given the volatility in rates that we have surrounding us. So we’ll continue to be opportunistic. And most specifically, we will continue to use the legacy liability structures that we have on the balance sheet to enhance the yields associated with those investments we do make. Tough to determine at this point whether that leads quarter-to-quarter to portfolio growth, but I think we’ll still — we’ll continue to be opportunistic when situations arise.

Sarah Barcomb: Okay. Thanks so much for taking the questions.

Bryan Donohoe: Thank you.

Operator: Our next question is from Steve Delaney with JMP Securities. Please proceed with your question.

Steven Delaney: Thanks. Good morning, everyone. Good to see you finding opportunities to deploy capital. I’m curious if you look at the terms of your new loans that you’re setting, how would you compare the levered returns that you’re able to obtain today versus sort of an average of if we were back in a 2021 first half 2022 type of environment, which I guess I’ll call a more normal environment. Thanks.

Bryan Donohoe: It’s a good question. I’d say that clearly, the bar is higher for new investments today. So you can expect to see those levered yields in excess of where they were at that point in time. One of the interesting factors right now is across the board, we’re seeing more and more appetite for warehouse lending from some of our counterparts on the banking side and starting to see that net interest margin or the gap between the whole loan pricing and repo get back to more normalized levels, which I think is a tailwind to new investments. So there’s some subtlety beyond that, though, as you’d expect, given the scarcity of capital in the space, those with capital can dictate terms to a better degree than maybe historically.

So that starts to impact covenants, leverage and certainly, as we said in the prepared remarks, Steve, the reset valuation just makes it a more attractive basis. So certainly an attractive time to invest in those circumstances that allow for it.