Please stand by, your program is about to begin. Good morning. Welcome to Ares's Commercial Real Estate Corporation's Fourth Quarter and Year End December 31, 2023 Earnings Conference Call. I will now turn the call over to Mr. John Stilmar, partner of public markets, Investor Relations.

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 the management team. In addition to our press release and the 10 K that we filed with the SEC, we have posted an earnings presentation under the Investor Resources section of our website at www.aresco.com. Before we begin, I will remind everyone that comments made during the course of this conference call and webcast, as well as the accompanying documents contain forward-looking statements that 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 filing. Various commercial real estate assumes no obligation to update any such forward-looking comments during this conference call. We'll 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 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. Good morning, everyone, and thank you for joining our fourth quarter 2023 earnings call. As I'm sure you are aware, we continue to see higher interest rates, higher rates of inflation, as well as certain cultural shifts such as work-from-home trends adversely impacting the operating performance and economic values of commercial real estate. This is particularly evident from many office properties. In addition, many properties requiring significant capital expenditures have been impacted by higher labor and material costs. Unfortunately, we are not immune to these macroeconomic challenges, and our results for 2023 and the fourth quarter are partially a reflection of these conditions. For the fourth quarter, we had a GAAP loss of $0.73 per common share, driven by a $47 million or $0.87 per common share increase in our CECL reserve, most of which is related to loans collateralized by office properties or a residential condominium construction project. Additionally, for the fourth quarter, we paid off six additional loans on nonaccrual status, which impacted both our GAAP and distributable earnings by approximately $0.12 per common share versus what these six loans contributed in the third quarter of 2023. As a result, our distributable earnings for the fourth quarter were $0.20 per common share. Fortunately, we are starting to see some positive trends in the macroeconomic environment that we believe are likely to benefit commercial real estate, including the potential for declining short-term interest rates, specifically declining spreads on CMBS and CRECLMs. Particularly during the past six months, we have seen strength in capital markets conditions, positive leasing momentum in certain sectors, including industrial and self-storage, and continued healthy demand trends for multifamily assets underscore some of the opportunities we see in today's market. These trends play out across our portfolio, particularly for loans centered risk-rated one to three, which totaled about $1.6 billion in outstanding principal balance. The risk-rated one through three portfolio is focused on senior first lien positions and is diversified across 37 loans. The majority of these loans are collateralized by multifamily, industrial, and self-storage properties, with the largest focus on multifamily properties at 34%, which is a positive indication of our commitment to the properties that contributed more than $150 million of capital, representing about 10% of the $1.6 billion in principal balance of these loans. A portion of this $150 million was used to renew all interest rate caps that expired in 2023 at their prior strike rate, credit, an economically equivalent amount after considering additional reserves. Let's now turn to our strategic plan to resolve the nine remaining risk-rated four or five loans that comprise about $539 million in outstanding principal balance and $1 million held for sale with a carrying value of $39 million as of year-end 2023. As we mentioned, the bonds are primarily collateralized by office properties and one residential condo problem. First, we will fully leverage the management capabilities of the Ares Real Estate Group, as we have discussed previously. The Ares Real Estate Group has more than 250 investment professionals and currently manages more than 500 investments globally, totaling approximately $50 billion in assets under management. We intend to use these capabilities to resolve underperforming loans held. Second, we have both significant loss reserves against these risk-rated four and five loans; as of December 31, 2023, 91% of our total $163 million in CECL reserves, or $149 million, relates to these nine loans, which comprise about 28% of the $539 million in outstanding principal balance. Finally, we have been highly purposeful in positioning our balance sheet over the past few years to provide us with greater flexibility and time to resolve these underperforming loans. For example, our net debt to equity has declined from 2.6 times at year end 2021 to 1.9 times at year end 2023, in both cases for the impact of CECL reserves on our shareholder equity. In addition, we have accumulated additional available capital totaling $185 million. All of these measures and capabilities have positioned us to work through our underperforming loans while balancing the goal of maximizing proceeds with accelerating the timeframe for resolution. So far, we've made some notable progress towards these goals. First, at the end of January 2024, we successfully sold a $39 million senior loan held for sale at a price equal to its year end 2023 carrying value. Second, although we did not close on the sale of the office property in Illinois that backed our $57 million senior loan before year end 2023, our borrower was under an agreement to sell the underlying property in the coming months, and we are working diligently to resolve three additional loans in the next few months. One loan will likely be resolved through the sale of the underlying property, and the other two may involve restructuring terms of the loan so that we can return a significant portion of the principal balance to accrual status, including having the borrower contribute additional capital to the problem. Now let me provide some additional background on our dividend of $0.25 per share that our Board of Directors has declared for the first quarter of 2024. Since our initial public offering nearly 12 years ago, we have operated with a framework that considers our distributable earnings power when setting the quarterly dividend. Up until this point, we have not reduced or delayed our quarterly dividend. In fact, we provided $0.02 per share in supplemental dividends for 10 quarters. In this current market environment, however, we believe it is in the best interest of ACRE and its stakeholders to reduce the quarterly dividend to help preserve book value and to pay out an amount more in line with our expected near-term quarterly distributable earnings before unrealized losses. Ultimately, as we get through this cycle, naturally as we execute on our earnings opportunities, we expect we can return to higher levels of profitability.

Thank you, Bryan, and good morning, everyone. For the fourth quarter of 2023, we reported a GAAP net loss of $39.4 million or $0.73 per common share. As Bryan mentioned, our GAAP net income was adversely impacted by a $47.5 million increase in our CECL provision, or about $0.87 per common share. For full year 2023, we reported a GAAP net loss of $38.9 million, or $0.72 per common share, and distributable earnings of $58.4 million, or $1.60 per common share. Our book value per common share now stands at $11.56, down from $14.57, excluding a $3.1 per share CECL reserve. Distributable earnings for the fourth quarter of 2023 was $10.8 million, or $0.20 per common share, which was adversely impacted by the six additional loans that were placed on nonaccrual in the fourth quarter. Our overall CECL reserve now stands at $163 million, representing 7.6% of the outstanding principal balance of our loans held for investment. 91% of our total $163 million in CECL reserve, or $149 million, relates to our risk-rated four and five loans, including $57 million of loss reserves on our three risk-rated five loans and $92 million of loss reserves on our six risk-rated four loans. Overall, the $149 million of reserves represents 28% of the outstanding principal balance of risk-rated four and five loans held for investment. We continue to further bolster our liquidity and capital position. We maintain significant liquidity with a moderate net debt to equity ratio of 1.9 times at year end 2023, including adding back our CECL reserves to shareholders' equity. Our financing sources are diverse and importantly have no spread-based mark-to-market provisions. As of December 31, 2023, we had over $185 million in cash and undrawn availability under our working capital facility. This amount does not include other potential sources of additional capital, including loans and properties. During the year, our liquidity was further supported by $280 million of repayments and loan sales. Our net realized losses for 2023 were $10.5 million. Since our IPO in 2012, we have closed over $8 billion in commercial real estate loans and through December 31, 2023, we have recognized a total of $14.5 million in realized losses. Finally, as Bryan mentioned, we declared a regular cash dividend of $0.25 per common share for the first quarter of 2024. This first quarter dividend will be payable on April 16, 2024 for common stockholders of record as of March 28, 2024.

You will recognize the challenges that we face with these new non-accrual loans and the impact that they had on our financial results for the fourth quarter. Based on the progress that we are making with respect to these new problem loans, we do expect to improve our run rate distributable earnings in the near term as we seek to recapture a portion of the lost earnings that we experienced in our fourth quarter. Our new quarterly dividend of $0.25 per share reflects our go-forward view of our near-term quarterly run rate distributable earnings, excluding losses, assuming we achieve the earnings enhancements from our contemplated restorations. Longer-term, we believe the real estate capabilities we possess at Ares, coupled with our capital liquidity and reserves, will enable us to maximize credit outcomes and enhance our earnings from these situations. We are cautiously optimistic that the increasing level of transaction activity and improving market liquidity will gradually provide more confidence for market participants over time and position us to return to a higher level of earnings in the future. As always, we appreciate you joining our call today, and we'd be happy to open the line for questions.

We’ll take a question from Sarah Barcomb of BTIG.

Good morning, everyone. Thank you for taking the question. I'm hoping you could walk us through your go-forward earnings power relative to this new $0.25 dividend, just with the Q4 DE coming in closer to $0.20. I'm hoping you can help us bridge that gap and for coverage in the coming quarters?

Sure. Good morning. Thank you very much for your question, Sarah. As we mentioned in our prepared remarks, the impact of putting six new loans on non-accrual had about a $0.12 impact from what those same loans net earned in prior quarters, the third quarter. However, as Bryan also mentioned, we are working very hard to resolve a number of those six new non-accrual loans as well as loans that had previously been placed on non-accrual status. One of those loans, the $39 million loan in California, has been successfully resolved. As we continue to resolve additional loans, I think we're making good progress on resolving a number of those non-accrual loans. We are targeting to resolve these loans as quickly as we can. We believe that once we resolve these loans, our earnings power will increase from the $0.20 recognized in the fourth quarter 2023, largely because that was impacted by the significant increase in non-accrual loans. Ultimately, that is our goal, to resolve these loans and increase our earnings power to continue covering the dividend that we have set.

Thank you. I appreciate you walking us through the property loan by loan, your expected resolution there. So thanks for that. On the comps a bit more backward-looking, but I'm hoping you could walk us through what happened on the ground with those new non-accrual loans, whether it was an issue at the sponsor level, with buying a new rate, or something else needing leasing-related; any color for us?

Yes, I can provide a bit more color. Each situation is somewhat unique, but borrower behavior, shifting sentiment around an asset, and support for that asset all crystallized in some of the valuations we've observed. There was more market activity in Q4 than we had seen previously, providing data points, along with certain events within each of the specific assets where the borrowers' commitment to continuing payments became more tenuous. This combination of factors led us to revisit our approach.

We’ll take our next question from Stephen Laws of Raymond James.

Hi, good morning. Follow-up a little bit on Sarah’s question. When you think about the potential earnings benefit as some of the non-accruals are resolved, is that really solely related to paying off the financing associated with these loans? Or does it also include some assumptions around redeploying capital in new investments?

Great question, Stephen. The answer is indeed a combination of factors, including the two examples you mentioned. Yes, in some cases, the benefit that we will see in earnings comes from paying down either in part or in full the associated liabilities of some of the non-accrual loans. So clearly, while these loans are already on non-accrual, we are still paying interest on the associated liabilities. Therefore, resolving these loans and obtaining full or partial repayment of the associated liabilities will obviously result in higher net income. Additionally, as you mentioned, some of the resolutions may provide us with cash that we could then redeploy into new investments. Another example would be that if we can restructure a loan with existing borrowers, we believe in some situations, we can have the borrower contribute additional capital, allowing us to begin recognizing interest on some or all of the existing loan itself. Those are three examples of how resolving the loans could increase earnings moving forward.

I appreciate the information. Based on that, were the six new non-accrual loans on non-accrual for the entire fourth quarter, or did they generate some interest income earlier in the quarter?

Our policy is that we put a loan on non-accrual for the entire quarter. Thus, when we discuss the $0.12 impact, we mean that for the entire fourth quarter, these six loans did not recognize any interest revenue for that period.

Okay, thank you for clarifying that. And then as we think about the interest coverage test, I think it's a 12-month look-back, but can you provide an update on that, and whether you'll need waivers for lower interest coverage test metrics or how the discussions are going with counterparties around the developments with these loans?

Certainly, Stephen. We have always closely monitored all of the covenants on our debt facilities, and we have been very proactive in deleveraging our balance sheet over the past several years. We have about $1 billion to $1.6 billion in financing that is materially down from a couple of years ago, and this has provided us with flexibility. We have increased our liquidity and have implemented measures to ensure that we can address the performance of our loans. Overall, this strategy has helped minimize the stress on meeting our covenants. For example, when we were leveraged at three to one, we were clearly at the tighter end of the interest coverage metrics. Thanks to our efforts, we've managed to significantly reduce our leverage in the past few years, and it has positively impacted our loan covenants.

Great. Appreciate the comments this morning, and we look forward to hearing about some of these resolutions in the next couple of quarters.

We’ll take our next question from Rick Shane of JPMorgan.

Thanks, everybody, for taking my questions this morning. Most have really been asked, but I just want to make sure on the loan that was held for sale and sold at your carrying value; is that correct? So no hit to book value by our calculations? That represents about a $2.6 million realized loss; is that correct?

Good morning. We sold the loan at $39 million. This was the net proceeds received from the sale, which equaled its stated fair value. It's essential to note that, because we were under contract to sell this loan at year-end, we classified this loan as available for sale instead of investing in it. Therefore, it is not included in our held-for-investment portfolio. As a result, it was not measured at fair value, so there was no impact on our book value. I'm not certain about the $2.6 million figure you mentioned, but the primary point here is that it was sold at its stated fair value.

Got it. And when we look at the $150 million specific CECL reserve, should the assumption be, particularly since it's clear you guys have an incentive to resolve this quickly and be able to redeploy the capital to achieve the distributable earnings run rate that you're targeting? Do you anticipate that those losses will largely come through in the first half with the cadence of realized losses being front-loaded in 2024?

We have a rigorous process in place to determine the appropriate amount of the CECL reserve, which may not necessarily reflect what will ultimately be realized, as these markets are highly dynamic. While we are actively working on our funds, some of these are immediate opportunities, and others will develop over later quarters. I wouldn’t expect all realized losses to occur in the first half. We are constantly balancing maximizing proceeds with the timeframe for resolution. In some situations, we may find it beneficial to hold onto an asset for a longer time to capture additional value, while in others, we are pushing hard for quick realizations. Thus, the realization of losses can vary significantly.

The leverage ratio that Tae-Sik mentioned gives us that flexibility. I also appreciate your concerns, and velocity is indeed important, but we must balance that with optimal resolution. We are looking forward to re-engaging in a more aggressive manner when conditions allow, and I believe resolving some of these assets will help indicate that.

Hi, and a question on it, I think we see the logic here in terms of where the dividend has been struck. If we think about where book value is today, looking at book value excluding reserves, we see the dividend equates to a yield and a book of just over 8.5%. Consistent with mid-cycle returns for your company on a scale basis over the long term. Is that the right way to be thinking of these things?

That's an excellent observation. One way to triangulate to a yield that makes sense is indeed through that perspective. I would, however, caution you, considering we are in dynamic market times. On one hand, we are experiencing high interest rates, while on the other hand, these elevated rates are causing significant adverse impacts on the operating performance and values of real estate. Many components contribute to our overall returns, including credit, interest rates, leverage, among others. That said, I agree that the $0.25 dividend for the first quarter, when annualized, provides an attractive yield. However, I want to emphasize that the story is not yet complete. We based our dividend level on what we believe we can earn by addressing some of the non-accrual loans but not all of them. Therefore, there is potential for increasing earnings at the same time we address various factors impacting our earnings going forward.

Got it. But I think it's an interesting observation you made. Considering the long-term average, I would agree that, on average, we have probably seen six years at a consistent 8% yield, two years above it, and two years below it. We are likely in the midst of two or three years below that 8.5% target.

Yes.

I guess I'm trying to just get a sense of your confidence level. As you think about the short term, how do you feel about the ability to avoid a repeat of Q1 where you have non-accrual migration and possibly another significant reserve build? I know there's uncertainty in the intermediate and longer term, but how do you view it in the short term?

Our short-term objectives are part of a longer-term plan, of course. We aim to remain extremely focused on non-performing loans and continue to monitor all our loans vigilantly. As of the fourth quarter, we have a significant portion of our capital invested in non-accrual loans, which has impacted our current income. However, many of our loans on non-accrual continue to pay interest, which isn’t recognized as income but reduces the carrying value of the loan itself. As a result, we've been able to improve the balance sheet overall. In short, we will keep our focus on enhancing our income base and our distributable earnings while actively working out any problem assets so that we can monetize our capital and reduce liabilities linked to non-performing loans.

We’ll take our next question from Steve Delaney of Citizens JMP.

Thank you. Good morning, Bryan and Tae-Sik. We’re starting to see something interesting this quarter and hearing anecdotes that a number of debt funds or even hedge funds are looking around for opportunities to opportunistically buy loans. I’m sure they’re talking to the banks, but we've seen evidence that they've also been speaking with commercial mortgage REITs. I'm curious if you're receiving inquiries from third parties looking to step in so that you can avoid foreclosure and instead sell the loan to someone who can operate differently than a public company. Just curious whether you're seeing that secondary market for distressed loans picking up?

That's an excellent question, Steve. The loan we held for sale at year-end is a strong example of executing on that strategy. There are two major narratives in commercial real estate: one related to the wall of maturity and the other related to the wall of capital. As the macro environment shifts, we have seen a relocation of capital that is becoming increasingly pro-business. Reflected in the market activity, the first market opportunity in commercial real estate will likely come in the form of credit, whether new loans that are attractive on a relative value basis or loans being purchased for control or yields. I expect that the activity will continue to progress at a rapid pace.

I appreciate that. I would have to think the Fed has kind of given us a head fake here. But as we start getting into the middle of this year, with more of an expectation for cuts in the second half, those potential buyers may become more aggressive as it fosters a positive sentiment in the market. Thus, they'll be less inclined to sell at significant discounts. I see this distressed and opportunistic money really picking up as the year progresses.

I think your assessment is very insightful. The concentration of commercial real estate debt among banks means that even a small shift in the allocation of real estate debt from banks to private markets will create substantial opportunities for investment. This scenario is precisely what Ares and our peers are preparing for as it promises to be an excellent opportunity to partner with banks in the next evolution of real estate debt markets.

We’ll take our next question from Doug Harter of UBS.

Thanks. I was just hoping you'd give a little more update on the multifamily portfolio and how it's responding given the move in rates. How do you think that portfolio is going to cope with refinancing?

The multifamily market generally benefits from continued capital markets participation from Fannie and Freddie, alongside being more friendly loans for banks. Overall, we have noted a national uptick in supply, and various markets are receiving different responses. Within our portfolio, we have observed positive leasing progress. Despite the challenges, I think it will present ongoing opportunities for the foreseeable future. Structurally, we're still facing a shortage of four to six million residents in the U.S. over the next five years, especially considering the macro-level return of immigration. The shortages relayed to short-term supply issues are significantly overshadowed by the long-term fundamental shortage, leading to better performance of the underlying assets. To summarize, we have seen relatively stable performance in our multifamily portfolio, and we anticipate that capital markets functionality will continue to support these assets.

We’ll move next to Jade Rahmani of KBW.

Thank you very much. Just to follow up on your answer to Doug's question, Green Street estimates that multi-family values are down around 28% from the peak. When we hear answers like that, it seems under-discussed. So, either we disagree with Green Street, or we need to recognize that there's capital stress in a lot of the multifamily deals that saw record issuance in 2021 and 2022. So, how do you expect that to be reconciled over the next year in multifamily? Secondly, I would like to ask about two multifamily properties in which Ares was involved. I believe they are likely in your portfolio; one is a large Chicago multifamily and the other is in Dallas. These appear to be outperforming expectations.

Jade, I think the phenomenon you mentioned represents a nuanced view. If you consider markets before spring of 2022, where purchasing was done at trough cap rates, the value decline in those cases may exceed the 28% you mentioned from Green Street. However, instances of rent growth in specific markets are encouraging; some buyers saw significant rent growth continuing. However, concerns about rising expenses have blurred those optimistic perspectives. As a lender, with manageable leverage, even if we accept the Green Street data, some equity remains to protect those assets. Thus, while distress is certainly a possibility, I believe loss severity, especially relative to the lending community, will be less pronounced compared to the office sector, for example. It's important to note that transfers of value from equity to debt may occur, but I believe the overall impact will be limited. Regarding the two assets you referenced, they actually reside in different vehicles than ACRE and are not connected to our specific portfolio.

Thanks, I appreciate that. Regarding the transfer of assets within a portfolio like mortgage REITs, if you don’t expect significant loss severity for lenders, how do you anticipate that will unfold? Do you see mortgage REITs bringing in extra capital to recapitalize transactions?

That is certainly a possibility. However, the technology overlay we have seen in the multifamily sector indicates that asset management skills within borrower communities have never been more crucial. To effectively build value, strong management is needed. I believe that, as you suggested, many transactions will involve partnerships rather than outright sales. This will provide mechanisms to stabilize the valuations. Alongside earlier points regarding declining rates and their stability over next five years, I think we’ll see stronger correlation with the rate environment's impact on multifamily.

Okay, thanks a lot. Lastly, there was an industrial property that moved to non-accrual status. It's relatively smaller compared to the average at $19 million, but we haven't seen much pressure there. Could you comment on that duration?

Yes, this is a redeveloped asset on the West Coast. We have actively analyzed the property, and dialogue with the borrower has been dynamic. Though it is a smaller asset, we are having ongoing discussions regarding the rate cap, and that's currently a catalyst for developments here.

The reason the non-accrual was assigned to this property was due to slower than expected leasing activity combined with a near-term event associated with the rate cap.

And there are no further questions at this time. I'd be happy to return the call to Bryan Donohoe for closing comments.

Thank you, operator. I just want to thank everybody for their time today. We appreciate the continued support of Ares's Commercial Real Estate, and we look forward to speaking with you again on our next earnings call. Thank you.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately one hour after the end of this call through March 21, 2024, to domestic callers by dialing 1-800-723-0544 and to international callers by dialing area code 402-220-2656. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website.