Ares Commercial Real Estate Corp Q3 FY2022 Earnings Call

Good afternoon, and welcome to Ares Commercial Real Estate Corporation's Conference Call to discuss the company's third quarter 2022 financial results. As a reminder, this conference call is being recorded on November 2, 2022. I will now turn the call over to John Stilmar from Investor Relations. Please go ahead.

Good afternoon, and thank you for joining us on today's conference call. I'm joined by our CEO, Bryan Donohoe; Tae-Sik Yoon, our CFO and other members of our team. 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’ll 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 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 documents. Ares Commercial Real Estate Corporation assumes no obligation to update any such forward-looking statements. During this conference call, we will likely refer to non-GAAP financial measures. We use these as a measure 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'd like to turn the call over to our CEO, Bryan Donohoe.

Thanks, John, and good afternoon everybody. This morning, we announced third quarter distributable earnings of $0.39 per share, an increase of 5% from the third quarter of last year, which exceeded our quarterly regular and supplemental dividends paid of $0.35 per share. The growth in our distributable earnings was driven primarily by the benefits of rising interest rates and some modest prepayment fees received. Looking forward, we expect that rising interest rates will continue to have a positive impact on our earnings potential due to our floating rate loan portfolio and the hedges we have in place on our liabilities. Now, let me touch on a few macro-economic factors influencing our markets. The Federal Reserve is continuing to tighten monetary policy with an unexpected pace of increases in market rates to combat inflation, which we believe has increased the likelihood of a recession. These complex macro cross currents are driving volatility across most major asset classes, including commercial real estate. Additionally, these factors are impairing capital formation as both the capital markets and bank lending have meaningfully retrenched, resulting in significantly expanded risk premiums. We believe these conditions are likely to persist for the foreseeable future, and there'll be challenges for our industry. Because of all this, the sourcing, informational benefits, and deep financing relationships that we derive as part of the Ares platform will be even more important for us in this type of environment. We have been focused on property types such as multifamily, industrial and self-storage that have strong underlying rent growth dynamics, which have muted or outpaced the recent growth in market interest rates. This has been particularly true since we exited the COVID time period at the end of 2020. In terms of deployments during the third quarter, we were highly selective. We closed $50 million of floating rate investments across multifamily and self-storage properties and $28 million of AAA-rated, newly issued CRE liquid debt securities. Across both public and private market opportunities, we believe that our new investments are on property types and markets with strong underlying demand drivers to counteract higher rates and risk premiums, while also possessing more conservative structures and wider spreads. By way of example, during the third quarter, we originated a senior whole loan secured by a portfolio of well-located multifamily properties in the Sunbelt with a well-regarded repeat sponsor. The all-in spread on the whole loans was 80 basis points higher than our post-pandemic average spreads for multifamily whole loans and with a greater equity subordination and enhanced structural terms, further driving the attractiveness of the loan. Supported by these attributes and the breadth of Ares' capital markets relationships, we were able to arrange highly efficient senior financing with an insurance company on this loan with ACRE retaining a $20.6 million mezzanine investment. We view this mezzanine investment as similar in concept to underwriting and holding a first lien loan on our balance sheet and financing a portion of the loan with one of our non-recourse financing sources. We also took advantage of what we believe are compelling opportunities in the CMBS markets by purchasing $28 million of newly issued AAA-rated CRE securities, backed by a pool of senior floating rate mortgages. We believe these securities are highly attractive investments with weighted average credit spreads of 245 basis points, resulting in unlevered yields today in excess of 6% at current SOFR rates, all backed by a diversified pool of underlying commercial real estate properties with LTVs of 30% to 40%. Despite the slower market, we had $167 million of repayments during the third quarter. This level of repayments was in line with our six-quarter average and included a $30 million hospitality loan with a risk rated four loan one year ago and was repaid at par during the third quarter. For the fourth quarter, we remain selective on new investments and expect to maintain a strong liquidity position. Now let me turn the call over to Tae-Sik to walk through our quarterly financial highlights and further details on our portfolio and capital position.

Great, thank you, Bryan, and good afternoon, everyone. This morning, we reported GAAP net income of $644,000 or $0.01 per share and distributable earnings of $21.3 million or $0.39 per share. The primary driver of the difference between our third quarter GAAP EPS and distributable EPS is approximately $19.5 million or about $0.36 per share in CECL provision we've recorded during the quarter. This provision serves to increase our overall CECL reserve to $51.9 million or approximately 1.9% of the total commitments of our loan portfolio, which I will cover shortly in more detail. Overall, our distributable earnings for the third quarter were supported by the positive benefits of rising interest rates and the continued contributions from our proactive approach for liability hedging that we put in place in early 2021 when market interest rates were materially lower than they are today and allowed us to lock in one-month LIBOR at 21 basis points. Turning to our portfolio. We ended the quarter with a loan portfolio consisting of 98% senior loans and an outstanding principal balance of $2.5 billion across 70 loans. During the third quarter, we collected 99% of our contractual interest due and added one new loan to non-accrual status. The three loans on non-accrual status represent about 4% of our overall portfolio as of September 30, 2022. In terms of our other credit quality metrics, 90% of our loan portfolio had a risk rating of three or better, which declined from 94% last quarter and primarily reflects the negative migration of four loans during the third quarter. More specifically, the risk ratings on three loans, each backed by office properties were downgraded from three to four due to our outlook on their respective business plans and our macroeconomic viewpoint of their respective submarkets. In addition, the risk rating of one residential loan changed from four to five. Here, we expect the sale of the underlying property in the fourth quarter below our carrying value, resulting in a loss of approximately $2.4 million should the transaction be consummated. In terms of our overall CECL reserve, we increased our total reserve by $19.5 million as of the third quarter of 2022 and our total CECL reserve now stands at $51.9 million or 1.9% of our total loan commitments. Turning to our capitalization and liquidity. Our borrowing base remains highly diversified across eight various financing sources. And importantly, none of these financing structures have spread-based mark-to-market provisions. We have received no margin calls on our liabilities. We are also in a very strong liquidity position with approximately $156 million of available capital as of November 1. This includes cash and amounts available for us to draw under various debt facilities. Additionally, we have $130 million of cash in our FL3 securitization that can be used to finance new transactions at borrowing spreads of L plus 170, a significant discount at today's market. This healthy level of available capital should benefit us as we selectively invest in an increasingly attractive spread environment, while maintaining a significant level of liquidity due to uncertain market conditions. Let me now provide an update on our portfolio positioning and the potential earnings benefits from future increases in short-term interest rates. 98% of our portfolio as measured by outstanding principal balance is comprised of floating-rate loans indexed to either one-month LIBOR or SOFR, resulting in our portfolio being positioned to benefit from further increases in the respective indices. None of our LIBOR floors, which provided us with significant incremental revenues in the past two years, are currently in effect, which means that 98% of our assets are currently sensitive to further increases in base interest rates. In comparison, as we have hedged a meaningful portion of our floating rate debt through interest rate swaps or borrowed on a fixed-rate basis in the case of our term loan, about one third of our liabilities are not sensitive to increases in base interest rates. This means that ACRE is well positioned to benefit from today's rising rate environment. For example, on a pro forma basis, if LIBOR was 100 basis points higher than the actual September 30, 2022 levels and all other aspects of our portfolio remain constant as of the same date, our annualized distributable earnings as of the third quarter of 2022 would have been higher by approximately $11 million or $0.20 per share on a pro forma basis. Finally, this morning, we announced a fourth 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. So with that, let me turn the call back over to Bryan for some closing remarks.

Thanks, Tae-Sik. We recognize the challenges that rising interest rates and future economic uncertainty are expected to have on certain real estate properties. We believe Ares Commercial Real Estate remains well positioned to navigate the changing economic landscape. Our balance sheet continues to be in great shape with moderate leverage, no spread-based mark-to-market sources of financing and a strong level of available capital. While the competitive landscape remains highly favorable, we are finding opportunities to invest in higher yielding opportunities with better structural terms. We expect to remain highly selective in order to preserve our strong liquidity position during what we expect could continue to be a volatile period. With that, I'll ask the operator to open the line for questions.

Thank you. The first question we have on the phone lines comes from Steve DeLaney of JMP. Your line is now open.

Thanks, everyone, for taking my question. I'm interested in your securities purchases. As you evaluate that market opportunity, are you considering CMBS? I also wonder if you're looking at CLOs, especially given their recent spreads and the benefits of the floating rate feature. Additionally, while you're purchasing these assets at an attractive rate, are you employing repo financing to aim for a target low double-digit return? Thank you.

Yeah, absolutely. Thanks for the question, Steve. I think we actually think there are some compelling structural features within the CLO market as well. So between the two, we're somewhat agnostic. And you can certainly see a little bit of both. Thus far, we have not sought to lever those. So kind of a combination of both yield and liquidity thus far. There are some features in the market that we've been hesitant to utilize leverage against effectively mark-to-market securities like this. So that's something we've been somewhat hesitant to do with the volatility around us. We're exploring various structures to mitigate some of that, but it's certainly an attractive period of time to be up in the stack where spreads have candidly widened more than some of the mezzanine bonds as well.

Okay, great. I have a quick follow-up. I couldn't find the article, but I remember noticing in commercial mortgage alerts over the last month that there was mention of a resurgence in Freddie Mac Q series, and one of the articles specifically referenced ACRE. I'm curious if you're considering this as a financing option for a Q Series deal with Freddie since I know you prefer multifamily. Thanks.

Yeah, I'm not familiar with the article. To date, we have not explored this space, but in times of volatility that has been somewhat of a safe harbor and also an interesting yield play, that clearly tightened over the last five or so years to where it was less interesting to us as a broad platform, not even specific to ACRE. It's not outside the realm of possibility, but not something we've explored to date.

Okay. Thank you, Bryan.

Thank you. Your next question comes from Jade Rahmani of KBW. Your line is now open, Jade.

Thank you very much. Just broadly speaking, in the office space, do you think that it's primarily an issue of liquidity or lack thereof driving these heightened CECL reserves that the commercial mortgage REITs are taking as well as, in a few cases, loans at maturity default? Or do you think there's a more fundamental reassessment of office going on and that's adding to the valuation multiple decline that we're seeing?

That's a great question, Jade. There are definitely mixed signals in the market. In some areas, demand for rentals is declining, while in other areas, certain properties remain attractive due to strong cash flow or long-term leases, even amid volatility. This appeal in the office sector tends to persist in a more stable liquidity environment. As I mentioned, there are regulatory and other pressures affecting banks' exposure to office properties, which is also playing a role in how CECL is managed in this context.

Thank you very much. The CECL reserve, firstly, want to confirm, nearly all of it was a general reserve. Only the $2.4 million was loan specific, but more broadly speaking, did you review every loan and near-term upcoming maturities and the risk of maturity default there and take that into account? What are you expecting on the loan maturity side?

Sure, Jade. Thanks for that question. Yes, this is Tae-Sik. So to answer your first question, yes. Of the $19.5 million, we mentioned that there was one loan that had the $2.4 million in terms of specifics. Again, the change in the $19.5 million, just to clarify, was not all due to that $2.5 million; that $2.4 million already had a $1.5 million general reserve prior quarter. So that specific net change was really just the $900,000. But the remainder of the $19.5 million that you mentioned, that is all due to sort of changes in the general reserve under CECL. And then to answer your second question, clearly, one of the factors that go into the CECL model is the maturity data loan. So when a loan is three years out versus three months out, it does have a different impact on the CECL model. It definitely also has an impact on our outlook of what that property will be performing at the time of the maturity. And obviously, the closer you get to maturity, the more specific and the more precise, if you want to call it, we can be about it. So to answer your question, yes, the maturity date is definitely taken into consideration as part of the overall CECL reserve analysis.

And on the four risk-rated four bucket, $234 million, how many loans is that? And over what period do you expect some kind of a resolution?

Yeah. Again, if you look at the four rated loans. I believe there are six of them. And in terms of when they will be resolved, the good news is there are just a few that have sort of near-term maturities, but certainly, all six are the focus of Ares' intense asset management led by our team. We are in very, very close dialogue with each of the borrowers about the progress of the business plan, restructuring some of the loan terms if necessary. But again, I think they're all in various stages of completing their business plans. But the good news is there are a couple with some near maturities. The others do not have near-term maturities, but they are all being very, very actively pursued in terms of working very closely with the borrowers to make sure that we do everything we can to work with the borrowers to meet their business plans.

Great, thanks.

Thank you. Your next question comes from the line of Rick Shane with JP Morgan. Please go ahead when you're ready, Rick.

Thanks for taking my questions, everybody. And I think Jade has honed in on the same issue that I am which is that when we look at the portfolio there're obviously in the next three months some pretty significant maturities and then when you extend that to six months, an even greater percentage of the portfolio is maturing. One question and I apologize I should know this, but I’m just looking at the slide deck, can't remember off the top of my head. Is the maturity date that you're showing the original maturity date or the fully extended maturity date?

The date we're showing is the original maturity date.

Okay, so maybe. The date we're showing is the initial maturity date. Some as we mentioned.

The date we're showing is the initial maturity date. Some as we mentioned.

Yeah. So should we assume that for most loans that are shown there with what you can calculate pretty easily is that three-year initial maturity probably do have at least one, if not two, extensions available?

Yeah, I would say our standard loans do have built-in extensions, generally one or two one-year extensions, but most often, they are accompanied by some level of requirements that are necessary for them to be met, whether it's LTV, debt yield, certainly no existence of default, potentially payment of fees, different interest rates. But generally, there are built-in requirements about debt yields or LTVs.

I understand that there is a fee associated with those extensions, which is simply a part of our business model. When examining the loans in the portfolio, it is important to note that due to market changes and the concentration of originations, the pending maturities are primarily in the office sector, which is a significant concern at this time. Do you think that the sponsors are in a position financially, in terms of the covenants, and also willing to extend, or do you anticipate an increase in similar activities, like the recent deal from one of your competitors?

So I think we absolutely deal with each situation differently. I think if you look at our historical practice, we have been very working, again very closely with each borrower to make sure we give them every opportunity to continue to meet their business plans. I'd say, most often, we have asked for some level of concessions in order to provide an extension of their loans, right? Whether that is some sort of fee? Whether that's an increase in the interest rate? And probably most often some material contribution of additional equity capital to show their continued sponsorship in the deal. But again, our goal is to continue to work with each of our borrowers to give them every opportunity for success. We want them committed, both from an effort perspective, as well as capital perspective. At this point, I would say there are situations where again, it's ongoing discussions. I don't think we have situations where we have borrowers ready to throw us the key, if you want to call it that way. But certainly, borrowers do behave as an economic animal, and we do understand the situations in which they may be motivated to do so. And so again, we evaluate each of these situations very uniquely, individually. It depends on the borrower, it depends on the building, it depends on the submarket, it depends on so many different situations that it's hard to give a generic response. But again, I do think we do work very closely with each borrower to make sure that we have the best solution for us and for them.

I’d like to add to that, Tae-Sik, by mentioning another aspect I've hinted at regarding higher cash flowing assets. One advantage of office properties is that they typically have longer lease durations compared to apartments. This additional cash flow can be redirected through our cash management system to pay down loans or serve as extra collateral, especially during times of illiquidity in this sector. Tae-Sik covered various ways we manage this area effectively. The overall economic environment poses challenges, but we're addressing them on a case-by-case basis for each asset.

Got it. And look, I will make the observation that strategically over the decades that we followed you, the behavior has always been to work with borrowers. I mean, I think there are ends of the continuum in terms of aggressive resolution versus really partnering with borrowers, and I am not pining which I think is better or worse. I think it depends upon the lender. But I think the long history of your company is to really try to work with the sponsors and keep them in the properties.

I agree with your perspective. At Ares, our foundation is rooted in credit, and we certainly have the capability to engage in situations where our broader expertise can add value. Ultimately, our primary objective is to serve as a lender to these borrowers, helping them navigate challenging times and reach a more favorable environment, which allows us to enhance value at the asset level. This often results in mutually beneficial outcomes and fosters brand loyalty. I believe your assessment is accurate.

Yeah, you don't want to be running a hotel in White Plains ever again?

Not during COVID at least.

Fair enough. Thank you, guys.

Thanks for the time.

Thank you. We now have Doug Harter from Credit Suisse. Please go ahead when you're ready.

Thanks. Can you elaborate a bit more on the decision to allocate capital to AAA CMBS and the acceptance of a lower risk but also lower return? How does that compare to your thoughts on the timing of holding that capital versus using it for loans that are likely to yield higher returns?

Yeah. It was really a balance of the risk spectrum, and clearly, there's been a slowdown in transaction activity throughout the real estate space. We're coming off of a record transaction volume year last year. So still enough to do. And we actually are pretty happy with the lending environment. We're seeing great opportunities. So it's a fair question. We just felt the relative value to be able to print those tickets when we did with the additional upside as we said on the first question about the potential to lever those if given the right structure into a pretty interesting overall yield. But the combination of the unlevered yield plus the liquidity that is inherent in those securities made it something that was fairly compelling at the time. Again, we don't see it as changing the mandate here, right? We are going to be first mortgage lenders to commercial real estate borrowers in the top markets, et cetera, that you've heard us talk about previously. But at the time, given the dearth of transactions and a few of the crosscurrents we've mentioned, we felt it was pretty compelling.

And I believe you mentioned that the CLO or one of the CLOs has $130 million in cash. What is the timeframe for reinvestment? How much longer are the reinvestment rights for that CLO?

Sure. We mentioned that we have about $130 million of capacity that we could put into the CLO. This is our FL3 securitization. And again, one of the benefits of that securitization is we've managed to extend that revolving period for a number of times, again, really taking advantage of that, that there's really one participant who holds all of the investment-grade notes in that CLO. So we still have a decent amount of time to put in some additional collateral. We're still also hopeful that even when that expires, we'll continue to be able to renew it. I think we are right now in our third revolving period. And so, we do anticipate and hope that we can continue to do it. But clearly, we're hopeful that we can put the $130 million to work very soon well within the allotted time period of the replacement period.

And I guess, what limitations would there be for deployment there? Or would we expect that the first $130 million of the loans you do would kind of go into that CLO?

One of the limitations is that the owner of the investment-grade notes has the right to approve. We have worked with them over the years to ensure that the collateral we include in FL3 aligns with both our thesis and theirs. Therefore, we do not anticipate facing challenges in identifying the appropriate types of assets to include. But Bryan, would you like to add something?

I want to emphasize that the reason we established this partnership a few years ago was that we share similar views. We regularly communicate with that investor and prioritize utilizing the liability structure due to its in-the-money nature. We both see the market landscape in a similar way and believe it's a great opportunity for commercial real estate lenders to take advantage of the dislocation. This is a key focus for us, and we will work closely with our partner that we've been collaborating with for several years.

Thank you. We have our next question from Hagen with BTIG. Please go ahead when you're ready.

Hi, good afternoon. Hope you guys are well. How are you finding in your conversations both with sponsors and in your underwriting the impact of hedging interest rate risk against the backdrop of higher rates and volatility? How would you say the hedging of that risk is filtered into CRE values and the way that you guys reserve for credit?

Yeah, it's a good question. It's been a pretty amazing dynamic. I think you saw in our commentary and some others, the velocity of the rate change has been pretty significant. I would say as we converse with borrowers throughout our broad portfolio, it really is being handled both, I would say, systematically, as well as taking into account the expected further duration of the asset. When you take the risk premium associated with rate caps plus the way they're functioning today, which is effectively just prepaying interest in certain ways, we're trying to be logical and reasonable about how we do that, while making sure that we protect interest rates to the downside to the extent that the pivot we're all hearing about in real time doesn't necessarily come to be. So it's a conversation we're having quite often. And our view, clearly, as Tae-Sik has mentioned today and in prior quarters, we've generally taken advantage of rates in certain environments. Right now, I think it's both defensive and really is focusing on the underlying credit of the asset. Tae-Sik, I don't know if you have anything to add there? My thoughts are very much in line with what has been said. One of the challenges we face is that a few years ago, it was quite cheap for borrowers to obtain interest rate protection, which is something we typically require. While there was some initial resistance to this, many borrowers now recognize it as a wise decision. As Bryan pointed out, with the current rate volatility and higher absolute rates, it has become significantly more expensive to establish caps or any other forms of interest rate protection. Fortunately, borrowers now appreciate the value of these measures. Consequently, there is less resistance to adopting them, but the cost of implementing such protections poses a financial challenge.

Right, that's helpful. In the case where a loan does get extended, does the borrower need to execute a new, call it, at-the-market interest rate cap?

Yeah, and that's a great question. I mean, that is certainly a very, very, very live question that we face every day and again, we do push it very hard. That is one of the things that we want to make sure that we and the borrowers are protected against further increases in interest rates. And again, I don't think there is a resistance in terms of wanting to do so, but again, it may come down to affordability of what those interest rate caps and other protection mechanisms will cost to put in place. So it is certainly something that we push very hard for, but again, it's all part of the overall negotiation of what we would seek to have in place in order for us to consent to an extension.

Got it. Thank you, guys, very much.

Thank you, Eric.

Thank you. We have no further questions. And I like to turn the call back over to Bryan Donohoe for any final remarks.

Thank you very much. I just want to express my gratitude to the team for their commitment this quarter and throughout and certainly our thanks to our investors for their continued support. Thank you for the time today.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part, an archived replay of this conference call will be available approximately one hour after the call ends through November 30, 2022, to domestic callers by dialing 1-866-813-9403 and to international callers by dialing +44-204-525-0658. For all replays, please reference the conference number 933476. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website.