Ares Commercial Real Estate Corp Q1 FY2022 Earnings Call

Good afternoon, and welcome to Ares Commercial Real Estate Corporation's Conference Call to discuss the company's First 2022 Financial Results. As a reminder, this conference call is being recorded on May 3, 2022. I'll now turn the call over to Veronica Mayer from Investor Relations.

Thank you, Matt. Good afternoon and thank you for joining us on today's conference call. I am joined today by our CEO, Bryan Donohoe; Tae-Sik Yoon, our CFO; and Carl Drake, Head of Public Market, Investor Relations. In addition to our press release and the 10-Q that we filed with the SEC, we have 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 anticipates, believes, expects, intends, will, should, may, and similar 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 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 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-titled measures used by other companies. Now, I would like to turn the call over to our CEO, Bryan Donohoe.

Thanks, Veronica and good afternoon, everybody. Following a very strong end to last year, we believe we are well-positioned to continue to deliver attractive returns for our shareholders in 2022. During the first quarter, we leveraged the breadth of the Ares origination platform to navigate volatile and uncertain markets to originate $263 million of new loans. We continued this momentum with $123 million in loans closed-to-date in the second quarter, and we have more than $200 million in the closing process. The overall credit quality of the portfolio remains stable, and we finalized the sale of our only REO property, the Westchester Marriott Hotel. As Tae-Sik will discuss in detail, our earnings are positioned to continue to benefit from increases in interest rates due to our floating rate portfolio and the hedges we have on our liabilities. We began the year navigating significant market volatility caused by rising inflation, more aggressive Fed tightening and global conflicts, all of which served to further slow what is already a seasonally light quarter for activity. In the first two months of the quarter, we continued to be highly selective, and we believe that our patience was rewarded. Toward the end of the first quarter when our transaction flow and originations increased, we began to see more attractive credit spreads on new investments. Our first quarter distributable earnings of $0.34 per share were influenced by our more measured approach on new originations early in the quarter and, as we discussed in our last quarter's earnings call, the pull-forward impact of early prepayment-related fees that we recognized in the fourth quarter of last year. While we're pleased with our execution of the sale of this REO property, holding the asset through what is a seasonally weak quarter for this hotel, we incurred a loss of $0.03 per share in the quarter. We expect the accelerated pace of originations at wider spreads, coupled with increases in base interest rates to result in a pickup in distributable earnings for the second quarter. Our asset-sensitive balance sheet puts us in a great position to generate additional earnings, assuming interest rate increases throughout the year. As a result of these factors, we believe we are on track towards our goal of having distributable earnings cover our dividends for the full year, as we have done for the past five years. During the second quarter, we've seen investment opportunities with more conservative structures at wider spreads amidst the volatility. Our market visibility continues to increase from being a part of the broader Ares management global real estate strategy, which now has $46 billion of assets under management, including over $10 billion of real estate debt assets. Our presence in liquid and illiquid markets across the U.S. and Europe provides valuable insight into how we invest in dynamic markets. We also benefit from in-house specialized capabilities, like in the industrial sector, where we've been a top three buyer of U.S. industrial real estate over the past decade. This type of in-house expertise and the information that comes with it allows us to see trends in real time. As we've grown the real estate debt platform, we've also expanded our suite of products, which has allowed us to be even better partners to our sponsors and borrowers and to increase market share. We continue to find attractive opportunities in our target sectors like industrial and self-storage, which can complement investments in other sectors where we see attractive relative value. For example, in the first quarter, we found an opportunity on a unique destination hospitality property backed by a highly regarded sponsor at an attractive spread. In terms of geographic dispersion, we continue to see robust activity in the south and mid-Atlantic regions, where we see strong demographic growth drivers. Our originations this quarter were consistent with our existing portfolio, which is comprised of 99% senior loans and 98% in floating rate instruments, and continues to perform well. Let me now turn the call over to Tae-Sik to walk through our quarterly financial highlights.

Great, thank you, Bryan. And good afternoon, everyone. This morning, we report a GAAP net income of $16.2 million or $0.34 per common share, and distributable earnings of $16.3 million or $0.34 per common share. As Bryan discussed, our earnings were impacted in part by the timing of recognizing fees associated with earlier than expected repayments that were pulled forward into the fourth quarter of 2021. As we discussed in our last earnings call, in the fourth quarter of 2021, we saw repayments of $317 million, which included recognizing $0.04 per share of remaining unamortized fees as compared to just $0.01 per share in such fee recognition in Q1, 2022. In addition, our former REO asset, the Westchester Marriott experienced an operating loss for the quarter, which as Bryan mentioned, accounted for about $0.03 per share negative impact on distributable earnings for Q1, 2022. We ended the quarter with a diversified portfolio of 77 loans with an outstanding principal balance of $2.4 billion, up 27% year-over-year. In addition, we continue to benefit from our LIBOR floors, which had a weighted average rate of 0.98%. Our CECL reserve was at $24.7 million at 1Q, 2022, a slight decrease versus the amount held at the end of the fourth quarter of 2021. Our weighted average loan risk rating for the portfolio improved from 2.8 at year-end 2021 to 2.7 as of March 31, 2022, and no new loans were put on non-accrual during this first quarter of 2022. As a reminder, the unpaid principal balance of the two loans that continue to be on non-accrual represent less than 2% of our overall portfolio. I would also like to point out an inadvertent clerical error in the risk rating loan table in note 4 on page 20 of our 10-Q that was filed earlier this morning. In the table, the amount for year 2022 for risk rated for loans should have been $61 million and not zero. The total column amount for risk rated for loans should have been $163 million and not $102 million. Please note that this error was limited to this table and does not change our overall portfolio risk rating or our CECL reserves. We will be issuing a filing shortly to correct this inadvertent clerical error. Let me now provide an update on our portfolio positioning in the context of changes in short-term interest rates. As Bryan stated, our portfolio is currently positioned to benefit from increases in benchmark indices with 98% of our portfolio as measured by unpaid principal balance comprised of floating rate loans indexed to either LIBOR or SOFR. Taking into account our LIBOR floors, approximately 50% of our loans are sensitive to increases in interest rates and will benefit should we see further increases in LIBOR or SOFR above current rates. In addition, we continue to match fund our assets and liabilities and hedge a significant portion of our floating-rate debt, with interest rate swaps and fixed the interest rate on some of our long-term liabilities, including the $150 million term loan that we upsized, extended, and converted to fixed rate last year. Without our interest rate hedges, the pro forma impact of rising rates would have had the opposite impact and reduced our earnings. Additionally, as we continued to recalibrate our hedge positions to better align with forecasted changes in our portfolio, including repayments, as well as movements in interest rates, we unwound $170 million notional interest rate cap that generated an approximate $2 million realized gain or about $0.04 per share in distributable earnings for the first quarter of 2022. Finally, this morning, we announced a second quarter 2022 regular dividend of $0.33 per common share, as well as a continuation of our supplemental quarterly dividend of $0.02 per common share. At this point, it is the goal of the company to continue sharing a portion of the earnings benefit from LIBOR floors with shareholders through the $0.02 quarterly supplemental dividend, and to continue covering our regular and supplemental dividends fully from distributable earnings on an annual basis. So with that, let me turn the call back over to Bryan for some closing remarks.

Thanks, Tae-Sik. As we look further ahead in 2022, we believe our company is well-positioned from a market standpoint, and our balance sheet is strong with moderate leverage, and an attractive, asset sensitive position. We continue to be on track for another record year of originations and to maintain a stronger pace of investments compared to the first quarter. Before we take questions, we want to sincerely thank our team for all of their hard work, and our broader Ares colleagues for their partnership in these periods of volatility, where their breadth of experience has been incredibly valuable. I also want to thank all our shareholders for their continued support of the company. And with that, I'll ask the operator to open the line for questions.

Thank you. Our first question will come from Doug Harter with Credit Suisse. Please go ahead.

Thanks. Given the sensitivity you shared around rising short-term rates, can you just talk about how the Board and you are thinking about the supplemental dividend? And kind of how if that continues or that gets converted to kind of being a regular way dividend and kind of how you're thinking about that?

Sure. Good afternoon, Doug. Thank you for that question. When we introduced the $0.02 supplemental dividend in the first quarter of 2021, it was intended to share the additional benefits from LIBOR floors with our shareholders. The LIBOR floors have been running out over the past 15 months since we implemented that supplemental dividend. We mentioned that we would assess the $0.02 supplement for its continuation as a supplemental or permanent dividend, or possibly ending it. There are two key factors to consider. First, how quickly the loans with LIBOR floors run out, which has been consistent with our initial forecast so far. Second, the state of short-term interest rates at that time. For instance, if all the floors have run off while LIBOR remains low, it would be challenging to maintain the $0.02 dividend. Conversely, if the floors are still in place, it would be easier to sustain the payment. Additionally, even if the floors run out but we see rising interest rates, we might still be in a position to maintain the $0.02 supplemental dividend and potentially make it a permanent arrangement long-term. Overall, things are trending positively. We've observed recent increases in interest rates over the past weeks and months, so it’s a bit early to conclude, but the signs are encouraging as we are experiencing loan run-offs alongside rising base interest rates.

Got it. That makes sense. And then just around leverage, is the goal, the target still to kind of work towards kind of three times debt to equity?

It is. As we've mentioned, we were certainly above that number prior to the onset of the pandemic, and we have purposely reduced our leverage down to about 2.2 to more or less fortify the balance sheet during the pandemic at a time when liquidity and stability of the balance sheet was at a premium. I would say our business model, our earnings model is really predicated upon maintaining about a plus or minus three-to-one debt-to-equity. We're still beneath that amount. That gives us headroom to continue to do originations, leverage the balance sheet further, generate and optimize the earnings potential on the balance sheet. But that is certainly the goal and continues to be the goal is to be plus or minus 3, 3 times debt to equity.

Thank you.

Thank you, Doug.

Our next question will come from Steve Delaney with JMP Securities. Please go ahead.

Good afternoon, everyone. Thanks for taking the question. Bryan, appreciated your comments, I believe in your remarks about the repayments or Tae-Sik, apology, it may have been yours, because you were talking about the earnings. But appreciate the impact of your clarity around the repayments and the difference between a $0.04 benefit in 4Q and $0.01 here in the first quarter. So a $0.03 difference that helps us understand your bottom line number. Could you give us a little feel for the outlook for repayments? Maybe for what you're seeing here near term in the second quarter and then out for the sort of for the full year? That would be helpful. Thanks.

Sure, no, absolutely Steve. And again, thank you very much for your question. We do think repayments are starting to so call normalize, right? And normalized to us means that about a third of our portfolio tends to repay on your average year, right. And it makes sense given that we generally underwrite three-year loans. And although we do get some early repayments, I think it's hovered around a 2.5-year to three-year average. So to kind of think that our portfolio runs off by about a third each year has generally been correct. Obviously, during the pandemic, we've had different circumstances. But we do see the market in terms of repayments returning to a more normalized period. That would really sort of infer call it $800 million per year, based on a $2.4 billion portfolio, $200 million quarter, I'm a little reticent to even give a quarterly number because obviously there is variability quarter-to-quarter. It's very hard to predict, $200 million per quarter. I think it's much more easier to forecast $800 per year, just because things don't happen neatly in quarterly increments, but we do get a sense that it is returning back to fairly normalized circumstances. I think when we look at our near, medium, and long-term forecast, that continues to be where we see repayments happening.

Got it. The first quarter was right at $200 million and the fourth quarter was 50% higher, which helps explain the situation.

Correct.

Okay. I see that Doug got leverage. My comment is that whenever you have a quarter with figures like $0.41 and $0.34, it raises some questions. From my perspective, looking at the two sets of numbers from the fourth quarter and the first quarter, it seems that a figure in between might be more realistic considering all the adjustments, especially with the hotel operating loss and the derivative gain. However, I won't ask you to comment on that. It appears that the one-time items this quarter have worked against you more than helped. That's just my opinion regarding the $0.34 figure. That's all I have for now. Take care, and we'll talk again in the second quarter.

Sounds great. Thank you so much, Steve.

Our next question will come from Rick Shane with JPMorgan. Please go ahead.

Hey, guys, thanks for taking my question this morning. Look, obviously the markets evolve. There's an opportunity for you guys to improve pricing, improve term. I'm curious as the market shifts, if there are opportunities that are being created, either in geographies or in property types, that you were deemphasizing that are rebounding in terms of attractiveness?

Yeah. Great question, Rick, I'll answer it in two ways. First, some of the opportunities that we're seeing in the market are driven by the change in liability structures for many of our competitors, and many of the folks in the real estate debt space. What I'm referring to is those entities that are reliant upon the CLO market where you've seen such impactful widening, one that's causing spreads to widen across the board, in all liquid markets and even illiquids to a degree. And certainly, opening up some opportunities in that sense. From a geographic or product or sector-specific opportunity set, I think you can probably correlate those to how lenders structure their liabilities and find some of that. I wouldn't say that it's necessarily tied to geography as much. As we've touched on in previous quarters, our footprint allows us to be somewhat agnostic, but focus on where we're seeing demographic growth in the southeast and southwest, and those areas are not immune to the widening in the CLO market. So certainly see some opportunities there. And as we touched on in our prepared remarks, while our focus as a platform, real estate debt and equity is in industrial, is multifamily, is in self-storage, there are those one-off opportunities in office, in lodging that are going to consistently present themselves and we have the ability to underwrite those pretty efficiently.

Got it. Okay, it's helpful and it's actually good for you in terms of the broader markets, because sometimes, obviously, we look at things a little bit more narrowly or myopically perhaps. So it's helpful context. Thank you.

Absolutely.

Our next question will come from Jade Rahmani with KBW. Please go ahead.

Thank you very much. Can you discuss what you're observing in the market regarding the effects of higher rates, as overall coupons and spreads have risen significantly? How are borrowers in the market responding to that?

Thank you for your question, Jade. It's a good one. The situation is still evolving. Considering the factors you mentioned, along with others like the war in Ukraine, we have many dynamics at play, some of which are contradictory. There’s a quantitative aspect to our work. When borrowing costs go up, it affects the value of the underlying properties. However, this is somewhat counter to the inflation story, where our physical assets are now priced at a greater discount compared to replacement costs. In the sectors we focus on, such as industrial, multifamily, and self-storage, particularly with shorter lease durations in industrial, rents are rising faster than the effect of higher interest rates. Overall, industry transaction volume last year was noteworthy, but it's unlikely to continue at that pace this year; we anticipate some downward adjustment. Investors may be more cautious despite ongoing capital flows. As noted earlier, we have been particularly careful at the start of the quarter. Attractive opportunities have appeared in the latter half, and we still see some of that now. However, broadly speaking, it’s hard to ignore that some asset values will likely be affected by rising rates; buyers today have less purchasing power compared to six months ago.

Thank you very much. So it's not as if the current rate impact we've seen thus far, the rate move thus far, has frozen the market. There's still healthy degree of transactions.

When considering the natural life cycle of a real estate transaction, it's typically around 90 to 120 days from start to finish. What you are witnessing now is the result of transactions initiated before some of the more significant changes in spreads or base rates. The final outcome is still uncertain. However, from our specific perspective, there is still a lot of potential work to be done.

Okay, regarding the asset classes that have seen strong rent growth, particularly multifamily properties, do you believe that the internal rates of return have been operating a couple of hundred basis points above the required hurdle rates? This suggests that there is some flexibility in the projected returns to accommodate potential rate increases. Additionally, there is a significant amount of capital available. You could consider reducing leverage, which would alleviate interest rate expenses. Adjusting the loan term or opting for interest-only payments are also options. Do you feel that the model has capacity to manage some of the rate effects without negatively impacting values at this moment?

I think it depends on the timing of the acquisition and the specific location. Certainly, we are seeing rent growth that has and is expected to continue to outpace initial projections as we speak. However, some of the internal rate of return above the expected figures you mentioned is due to lower cap rates. If you look back at cap rates when they were similar to where they are now, or at least a couple of weeks ago, around 2019 levels, you would expect to see cap rates for multi and industrial assets widen from 3.5 to 4 to around 4.25 to 4.75, just based on interest rates. We have revisited that data, and it informs our underwriting process. Specific assets that have enjoyed rent growth—assets that would not have been projected as such—along with cap rate declines over the past couple of years, have been significant. Across the entire portfolio, many equity holders will benefit from this combination. It will be interesting to see if continued rent growth in those areas surpasses changes in cap rates. But I believe you are considering it correctly.

And are you changing at all your underwriting of multifamily? And is that still a sector ACRE is very focused on? The Fed has said that they want to get inflation under control. And I believe one-third of inflation is what they call the shelter index, which is a composite. And that includes rent growth. And if we're seeing new lease rent growth at 17%, and housing appreciation at 21%, it stands to reason that they absolutely need to slow the housing market and the rental market to control at least to reduce one-third of inflation. So are you at all moderating your assumptions in multifamily underwriting? And is that still a target asset class?

Great question. It remains a target asset class. At a macro level, one of the unique aspects of current inflation, similar to the situation in the 70s, is the supply side dynamic. To reduce rent growth, there are two main approaches: legislative changes and increasing supply. The United States experienced significant under-supply in housing from 2010 to 2020. Inflation has sharply raised the costs of developing new multifamily assets, limiting the options to reduce rent growth. We are assessing the underlying economy and considering scenarios where a recession or similar economic shift could mitigate the impact of rising rental rates. However, this isn't our base case at the moment. We expect continued rent growth in the near term, although it may moderate. Our main focus is the Affordability Index, as this is where we might see bad debt beginning to affect the financials of some residential-focused REITs. We're monitoring our portfolio closely for any signs of this. While we are not anticipating major changes, this area remains a key focus, and we are attentive to potential downside risks.

Thanks. One last question is ground leases, is that a competitive form of capital that you're seeing in the market currently?

I think the movement in rates is making that area quite dynamic. Over the last two quarters, with these changing dynamics, we have observed a slight decrease in participation in some ground lease businesses. We analyze it, and when we evaluate an asset, it essentially amounts to additional debt. I don't believe that market will surpass traditional financing options broadly. However, it is definitely an intriguing area to monitor.

Thank you for taking the questions.

Of course. Thank you.

Our next question will come from Stephen Laws with Raymond James. Please go ahead.

Hi, you've covered a lot already. But I wanted to ask about office, Bryan. It's about a third of the portfolio. I don't think you've originated loans in the office sector the last couple of quarters. But maybe what are you seeing there? You mentioned you might see some one-off opportunities there. But what are you seeing both opportunity wise in office? And then maybe update us on how that third of your loan book’s performing and what you're seeing inside the portfolio? Thank you.

Certainly. Looking back at the past 9 to 12 months, we observed some unique opportunities in the office sector. Today, the average rents in various markets do not fully convey the entire picture, and perhaps they never did. There is a significant divide in tenant demand, with newer properties that offer high-end amenities being more sought after. For instance, in the New York market, you can see that Class B rents are between $40 and $50, while Class A rents for newer developments seem to have no upper limit. We will remain selective regarding our opportunities in this space. From a portfolio management perspective, we are focused on tenant retention and the weighted average lease term. Our top office assets still benefit from lease durations exceeding five years, which is notably longer than the typical loan tenure we encounter. Therefore, we are monitoring this sector closely from a risk management standpoint and will continue to be cautious about expanding our portfolio in this area.

Right. Appreciate it, Bryan.

Of course, thank you.

Our next question will come from Eric Hagen with BTIG. Please go ahead.

Hey, thanks. Good afternoon. For the new originations in the quarter, does the yield of 7.1% use the forward SOFR curve at the end of the quarter? Do you think there’s potential for that to improve as the Fed raises rates? Can you also explain how the yield compares to the loans that were paid down during the period? Thanks.

Yeah, thank you, Eric. In terms of the quoted number, the unlevered effective yield, that is using the spot rate as of quarter end. These are floating rate loans, so they should go up in coupon and rate as further increases in rates happen. But the quoted number is based upon the spot rate today. In terms of what is running off, I don't have the exact number in terms of the unlevered effective yields of the loans that paid off this quarter. But it was certainly below what was originated for the first quarter. Again, it's based upon the March 31 rate, and not any sort of forward-looking curve or forward-looking rates.

Guys, that's really helpful. Thanks. Can you also talk about plans around managing the CLO that you sponsored in 2017, whether there's an opportunity to maybe refinance that or issue a new one? And maybe even more generally, can you point to any kind of catalyst for spreads to tighten in the CLO market right now?

In regard to our 2017 FL3 loan, this securitization has undergone several modifications to extend the management period, allowing us to replace loans that mature within the CLO structure. We have successfully placed this CLO with a single institutional buyer of all the investment-grade certificates and have worked closely with them to extend the revolving period and the term on two occasions. This exemplifies the benefits of being part of Ares Management, as we completed this CLO without the help of a third-party placement agent, saving significant costs in fees. More importantly, our strong relationship with the holder of the investment-grade notes has allowed this CLO to continue for over five years. This has been a significant advantage in managing the generally high costs associated with executing a CLO and in reducing the risks tied to market execution on new CLOs. Concerning the market changes in CLO spreads, we observed significant widening in the CLO market during the first few months of this year, though the pace of that widening seems to have slowed. However, we do not anticipate that spreads have tightened significantly toward the levels seen in 2021.

And I'll just pile on Eric, if I could just with respect to spreads for our underlying loans. I would say somewhere to what Tae-Sik said, it's tough to see what the catalysts would be for tightening as we sit here today. Normally when we see rising rates, we would see the compression in credit spreads, and we're just not seeing that right now. I think that's just a function of the market dynamic I touched on earlier. If you go through investment-grade corporates than the movements there, high yield is similar, and obviously the stock market being down 12%, 13% year-to-date. There's not a great catalyst for tightening. Overarching, I think this type of volatility is something that gets us excited, just given as we think about our own liability structure, not being reliant on the CLO market. And having steady partners that finance a good portion of our business as well as we touched on a bit earlier as well increasing our leverage to that three to one target. This is a pretty sound environment for us to invest.

That's really helpful. Thank you guys very much.

Thanks, Eric.

This concludes our question-and-answer session. I would like to turn the conference back over to Bryan Donohoe for any closing remarks.

Thanks. I just want to thank everybody for their time today. We certainly appreciate your continued support of ACRE and we look forward to speaking to you again in about 90 days. Thank you.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay, this conference call will be available approximately one hour after the end of this call through June 3, 2022. For domestic callers by dialing 1-877-344-7529 and for international callers by dialing 1-412-317-0088. For all replays please reference conference number 7027178. An archived replay will also be available on the webcast link located on the homepage of the investor resources section of our website.