Ares Commercial Real Estate Corporation (NYSE:ACRE) Q1 2024 Earnings Call Transcript

Ares Commercial Real Estate Corporation (NYSE:ACRE) Q1 2024 Earnings Call Transcript May 9, 2024

Ares Commercial Real Estate Corporation beats earnings expectations. Reported EPS is $-0.22654, expectations were $-0.3. ACRE isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning and welcome to the Ares Commercial Real Estate Corporation’s First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded on Thursday, May 9, 2024. I will now turn the call over to Mr. John Stilmar, Partner of Public Markets Investor Relations. Please go ahead.

John Stilmar: Good morning, and thank you for joining us on today’s conference call. I’m joined today by our CEO, Bryan Donohoe; our CFO, Tae-Sik Yoon, and other members of the management team. In addition to our press release and the 10-Q that we filed with the SEC, we’ve posted an earnings presentation under the Investor Resources section of our website at www.arescre.com. Before we begin, I want to remind everyone that comments made during the course of this conference call and webcast, 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 such expressions.

These forward-looking statements are based on management’s current expectation of market conditions and management’s judgment. The statements are not guarantees of future performance, condition, or results, involve a number of risks and uncertainties. The company’s actual results could differ materially from those expressed in the forward-looking statements as a result of a number of factors, including those listed in its SEC filings. Ares Commercial Real Estate assumes no obligation to update any such forward-looking statements. During this call, we will refer to certain non-GAAP financial measures. We use these as a measure of operating performance. 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. Bryan?

Bryan Donohoe: Thank you, John. During the first quarter, we made meaningful progress towards our goal of resolving underperforming loans, reducing the outstanding principal balance of nonaccrual loans by $133 million, as well as reducing our exposure to the commercial office property sector by $70 million, or 8% of our total loans backed by office properties. By addressing a total of 4 nonaccrual loans during the first quarter, we increased our distributable earnings, excluding losses, compared to the prior quarter, by approximately $0.02 per common share, and further delevered our balance sheet by $138 million to an outstanding balance of less than $1.5 billion at the end of the first quarter. Our focus remains on returning ACRE to its core business of originating loans and managing a portfolio of loans backed by commercial real estate properties in order to earn consistent income to support an attractive level of dividends for our shareholders.

Let me now provide more details on the loans that were resolved during the first quarter. First, we sold a $38 million loan that we held for sale at year end 2023 that was backed by a mixed-use property located in California that was on nonaccrual. Second, we agreed to a discounted loan payoff of a $19 million loan backed by a multifamily property located in the state of Washington that was on nonaccrual at the end of 2023. As a result of these initiatives, we realized a loss consistent with the fair value mark and loss reserves held on our balance sheet at year end 2023 and paid down $54 million of debt in our FL4 securitization. Third, we exited a $57 million Chicago risk rated 5 loan collateralized by a commercial office property that was also on nonaccrual at year end 2023.

As a result of this disposition, we realized a loss that was $3 million higher than the loss reserve held against this loan at year end 2023. And finally, we restructured a $74 million loan backed by a Class A newly rebuilt office building located in New York City. At closing of this restructure, the borrower paid down $5 million of principal, reducing the balance to $69 million, which was split between a $59 million A Note and a $10 million B Note. In addition, it is anticipated that the borrower will contribute additional capital into the building for additional new leasing costs, including tenant improvement allowances. To incentivize the contribution of additional capital, including the initial $5 million repayment of the loan, we have agreed to subordinate our $10 million B note to new equity contributed by the sponsor.

This restructuring resulted in returning the $59 million A Note to interest-earnings status while the B note remains on nonaccrual. As a result of addressing these 4 loans, the outstanding principal balance of loans on nonaccrual was reduced by 31% and our distributable earnings, excluding losses, increased by $0.02 per common share for the first quarter of 2024. Shifting now to our overall portfolio. We ended the quarter with 2 billion of outstanding principal balance across 44 loans. 36 loans totaling $1.5 billion, or 75% of our loan portfolio, had a risk rating of 3 or better. The majority of these loans are collateralized by multifamily, industrial, self-storage, and hospitality properties. As a reflection of the quality of our risk rated 3 or better loans, borrowers continue to be committed to these underlying properties.

Over the past 12 months, borrowers have contributed more than $130 million in additional capital relating to loans risk rated 3 or better and during the same time period all interest rate caps have been renewed at their prior strike or economically equivalent amounts have been deposited into reserves. Going forward, we will continue to focus on resolving our remaining 4 and 5 risk rated loans and to reduce our office exposure. During the second quarter, we expect to take a $33 million risk rated 5 loan, backed by an office building in California, as REO that is currently on nonaccrual. At this time, we believe that our loss reserve on this loan is substantially in line with our current estimate of a potential realized loss. Additionally, despite ongoing negotiations with the borrower, a $69 million loan to an office property located in North Carolina currently on nonaccrual defaulted after quarter end.

We’ve begun the process of taking title of the office property and importantly, this property is cash flowing such that if and when the property becomes REO, property level earnings will be recognized. With that, let me turn the call over to Tae-Sik to provide more details on our financial results and balance sheet positioning.

Tae-Sik Yoon: Thank you, Bryan, and good morning, everyone. For the first quarter of 2024, we reported a GAAP net loss of $12.3 million, or $0.23 per common share. Our distributable earnings loss for the first quarter of 2024 was $33.5 million, or $0.62 per common share and was driven by a realized loss of $45.7 million, or $0.84 cents per common share, due to exiting the 3 loans that Bryan mentioned earlier. Distributable earnings, excluding these realized losses, were $12.2 million, or $0.22 per common share, for the first quarter. Our overall CECL reserve now stands at $141 million, which declined by $22 million versus the $163 million CECL reserve we held as of December 31, 2023. This reduction was driven by a $42 million reversal of existing reserves associated with the realization of losses, partially offset by approximately $20 million of additional reserves on existing loans in the portfolio.

The overall CECl reserve of $141 million at quarter end represents 6.9% of the outstanding principal balance of our loans held for investment, which is down from 7.6% as of the prior quarter. 89% of our total CECL reserve, or $125 million, relates to our risk rated 4 or 5 loans, including $31 million of loss reserves on our 2 risk rated 5 loans and $94 million of loss reserves on our 6 risk rated 4 loans. Overall, the $125 million of reserves on our risk rated 4 or 5 loans represents 25% of the outstanding principal balance of such loans. Further, with respect to our loans that are risk rated 4 or 5 at quarter end, there were 8 loans totaling $503 million in outstanding principal balance. 77% of the outstanding principal balance of our risk rated 4 or 5 loans are collateralized by office and 1 residential condominium property.

We did downgrade 1 $97.5 million Texas multifamily loan to a risk rating of 4 from 3 during the first quarter as the timeline and process of the sale of the underlying property by the borrower has been extended. Before concluding, I want to provide more background on managing our balance sheet. Consistent with our goals, we continue to maintain significant liquidity and further reduced our third-party debt. Driven by the loan exit activities during the first quarter, we reduced our outstanding borrowings by $138 million, resulting in total third-party debt of less than $1.5 billion at March 31, 2024. And finally, we declared a regular cash dividend of $0.25 per common share for the second quarter of 2024. The second quarter dividend will be payable on July 16, 2024, to common stockholders of record as of June 28, 2024.

With that, I will turn the call back over to Bryan for some closing remarks.

Bryan Donohoe: Thank you, Tae-Sik. We are cautiously optimistic about the modest recovery we are seeing in the commercial real estate markets and tightening spreads in the CMBS capital markets will be supportive in the execution of our near-term goals. We are firmly focused on addressing our underperforming loans and further building liquidity in order to maximize outcomes as we seek to shift our focus from asset management to investing. The timing and path to resolving some of our current 4 and 5 risk rated loans may make our quarterly earnings trajectory uneven this year, including in the second quarter due to loan resolutions. We remain focused on resolving a number of the identified risk rated 4 and 5 loans in 2024, which we believe will enable us to achieve higher distributable earnings. As always, we appreciate you joining our call today, and we’d be happy to open the line for questions. Operator?

See also 10 Undervalued Stocks with Latest Insider Purchases and Top 10 Artificial Intelligence (AI) SEO Tools in 2024.

Q&A Session

Operator: [Operator Instructions] And our first question will come from Doug Harter with UBS.

Doug Harter: You talked about using the potentially move going back to investing this quarter. You used the resolution proceeds to pay down debt. Just how should we think about when you might pivot to investing versus continuing to delever the balance sheet?

Bryan Donohoe: Yes, appreciate the question, Doug. Good to hear from you. I think the playbook remains fairly similar to what we’ve said in prior quarters, which is a multipronged path towards resolution, where we’re considering a lot of options with the pursuit of generating more liquidity, which will give us then the optionality as to when we see the opportunities, which have started to present themselves beginning in Q4 with some of the rate stability. We saw a bit of a pause with the rate movement of the past 6 or 8 weeks, but ultimately, we are seeing more liquidity, more acceptance of revised asset values, and ultimately, as we work through the coming quarters, we would intend to get back to that offensive side of the ledger once we’ve crystallized some more liquidity on the balance sheet. So, the primary goal is to continue to resolve those risk rated 4 and 5s, and the liquidity that should come with those types of resolutions will allow us that flexibility.

Doug Harter: Appreciate that, Bryan. And Tae-Sik, can you give us some sense what sort of drag the 4 resolved loans, excluding the losses, had on earnings during the first quarter and how to think about the path back towards the dividend?

Tae-Sik Yoon: Sure. As we mentioned, the four loans that were either exited or restructured this quarter, so really the resolution of those four loans, either through, for example, the restructured loan having an A Note come back on earnings, and then the 3 exit of loans really paying down debt, the combination of that really added around $02.0 of distributable earnings during the first quarter. That run rate, if you want to call it that, the full quarter impact of that will be higher than the $0.02. But for the first quarter, I think, it was roughly $02.0 positive impact that it had on our first quarter earnings.

Operator: Our next question will come from Jade Rahmani with KBW.

Jason Sabshon: This is actually Jason Sabshon for Jade Rahmani. It would be helpful to hear an update on how things are going with your repo lenders and on the term loan.

Bryan Donohoe: Tae-Sik, do you want to kick off?

Tae-Sik Yoon: Yes. I think we’ve had and always maintained what we think is a very strong relationship with all of our lenders, warehouse lenders, term loan lenders, revolving credit facility lenders. And in fact, as you’ll notice in our filing this morning, we have continued to work with them, and we greatly appreciate the partnership we have with all of our lenders. But you can see that we continue to, for example, amend our credit facility so that we can, again, as part of our overall goal to resolve underperforming loans, optimize the balance sheet with flexibility. So, flexibility is very important to us. And again, we appreciate all the partnership we’ve had, our lenders who have been willing to work with us to create that additional flexibility on our balance sheet.

Jason Sabshon: Also, on the North Carolina office loan default, it would be helpful to hear more color on how you see that playing out.

Bryan Donohoe: Yes, I’ll give that a shot. I think, look, we obviously were attempting to work with the borrower. However, the capital necessary for us to restructure that loan and in keeping with what we accomplished on the New York loan that we covered in the prepared remarks didn’t necessarily make it rational. It’s also an asset, as we mentioned, that has positive cash flow, probably has some occupancy upside in a market that has seen some positive flows of corporate tenancy. So, we think there’s some value to be added with a functional ownership group. So, I think, the timeline for resolution there will be what it will be. I don’t think it’s a 1 to 2 quarter resolution necessarily. But when we look at situations like this, clearly, we want to see both expertise and capital come to bear on those assets.

And as you see in our earnings deck, we feel that we’re in a position to bring both of those as a fallback position to having attempted to work with the borrower. So, timeline will be determined over the next 60 to 90 days. And I think when we chat with you all in 90 days, we’ll have a more concrete plan there.

Jason Sabshon: And as a final question, understanding that each asset is unique, but generally, in your book, how have loss severities compared to your expectations specifically for office and multifamily loans, and general commentary on what you’re seeing in the market with respect to loss severities would be helpful as well?

Bryan Donohoe: I’ll start. Look, I think what we’ve attempted to do over the prior quarters has been to give our best estimate of where we expect to resolve assets and really limit surprises on these calls or dramatic changes in our outlook. And I think we’ve had some success doing that. As an industry, I would put forth that what’s gone on in the office sector has surprised many to the downside in terms of resolutions. That said, we’ve been as transparent as possible as we’ve worked through those. I think the lack of transparency generally in the market has probably delayed some resolutions throughout the broader space. And I think, as I said earlier, we’re starting to see that crystallize to some degree with stability in rates. So, I think over the coming quarters, you’ll see more resolutions in keeping with expectations.

Operator: Our next question comes from Stephen Laws with Raymond James.

Stephen Laws: At the risk of asking something you already mentioned, Bryan, I was a few minutes late, but can you talk about the nonaccruals? I believe it’s $292 million remaining. I know you guys made a lot of progress, but is there a goal on a some are near-term resolution, some are longer term, but maybe if you look to year end, do you have, say, an idea of where you’d like to exit the year on that number?