Ares Commercial Real Estate Corporation (NYSE:ACRE) Q4 2023 Earnings Call Transcript

Ares Commercial Real Estate Corporation (NYSE:ACRE) Q4 2023 Earnings Call Transcript February 22, 2024

Ares Commercial Real Estate Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

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

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 K that we filed with the SEC. We have posted an earnings presentation under the Investor Resources section of our website at w. w. w. dot Aries, CO.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 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 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. Bryan?

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. And fortunately, 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.

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Q&A Session

In addition, for the fourth quarter, we paid 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, our $0.2 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 CRECLM.s, particularly during the past six months, reflects 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 and risk-rated one through three portfolio as 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% as 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 and 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 Aries real estate group as we have discussed previously areas 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 four and five risk-rated loans as of December 31, 2023, 91% of our total $163 million and CECL reserve or $149 million as related to these nine months, which is about 28% of the $539 million in outstanding principal balance these five.

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 and told them $185 million. All of these measures and capabilities have positioned us to work through our underperforming redeploy while balancing the goal of maximizing proceeds of 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 and the coming 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. The other two may involve restriction in 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 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 of the switch on to pay out an amount more in line with our expected near-term quarterly distributable earnings before unrealized loss. Ultimately as we get through this cycle, naturally, as we execute on our earnings opportunities, as discussed, we expect we can return to higher levels of profitability that. Now, let me turn the call over to Tae-Sik.

Tae-Sik Yoon: 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. On full year 2023, we reported a GAAP net loss of $38.9 million. Our $0.72 per common share and distributable earnings of $58.4 million or $1.6 per common share. Our book value per common share and now stands at $11.56 for $14.57, excluding a $3.1 per share. CECL reserve distributable earnings for the fourth quarter of 2023 was $10.8 million or $0.2 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 interest, 91% of our total $163 million in CECL reserve for $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 at 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 base mark-to-market provisions.

At December 31, 2023, we had over $185 million in cash and undrawn availability under our working capital facility. This amount does not include other potentials potential sources of additional capital, including on one hand 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 was $10.5 million since our IPO in 2012 we have closed over $8 billion in commercial real estate loans and through December 31, 2023. And we recognized a total of $14.5 million and realized loss. And finally, as Bryan mentioned, we declared a regular cash dividend of $0.25 per common share for the first quarter of 2024. For this first quarter, dividend will be payable on April 16, 2024 for a common stockholders of record as of March 28, 2024.

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

Bryan Donohoe: You will recognize the challenges that we face with these new nonaccrual 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 Aries, 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 concerns to gradually provide more confidence for market participants over time in time as concerns 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.

Operator: [Operator Instructions] We’ll take a question from Sarah Barcomb of BTIG.

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

Tae-Sik Yoon: Sure. Good morning. Thank you very much for your question, Sarah. And as we mentioned on our prepared remarks, that the impact of putting six new loans on nonaccrual, you had about a $0.12 impact from what those same loans net earned in prior quarters, the third quarter. But as Bryan also mentioned, we are working very hard to resolve a number of those loans, a number of those six new nonaccrual loans as well as loans that as you have been previously placed on nonaccrual status, you mentioned one of those loans that $39 million loan out in California that has been successfully resolved. And as we continue to resolve additional loans, I think we’re making good progress on resolving a number of those nonaccrual loans and really in Yes, as we mentioned, kind of setting our dividend at the 25% level for the first quarter of 2024, we did take into account what we believe we can achieve in terms of the server earnings once we were able to successfully resolve some of these loans without getting too specific, I think we are we are targeting to resolve these loans on some of these loans as soon as we can.

So we do believe that once we are able to resolve these loans and as Mike mentioned, the resolution will come in a couple of different forms, in some cases, a sale of a loan, in some cases, sale of the underlying collateral. In some cases, restructuring of the loans with existing borrowers; so the resolutions are going to come in different forms. And we do believe that our earnings power that will go up from the $0.2 that we recognized in 20 in the fourth quarter of 2020, largely because that was impacted by, again the significant increase in nonaccrual loans. And so that is really our goal is to resolve these loans and increase our earnings power and so that we can continue to cover the dividend that we have set.

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

Bryan Donohoe: Yes, yes. I can have a bit more color. So I would say that each feature somebody Synchronics, but certainly borrower behavior, shifting sentiment around an asset and support for that asset as well as just really crystallizing some of the valuations that we’ve seen a bit more activity through Q4 fabless. So there was more data point to as well as certain events within each of the specific assets where the borrowers approach to continuing of those payments was more handouts and that nothing on the margin just had a few events that made us revisit some of the approach [ph].

Sarah Barcomb: Great. Thank you.

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

Stephen Laws: 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 is it also includes some assumptions around redeploying capital in new investments?

Tae-Sik Yoon: Sure. Great question, Stephen. And the answer really is it’s a combination of number of things, including the two examples that you mentioned. So yes, in some cases are the, you know, the arm and the benefit that we will see in earnings comes from being able to pay down either in part or full associated liability, some of the nonaccrual loans. So clearly alone, they’re already on nonaccrual. And so but unfortunately, we are still paying interest on the associated liability. So to the extent that we can resolve these loans and get a full or partial repayment of the associated liabilities that would obviously result in higher net income. And the other, as you mentioned, is that some of the resolutions have we believe will result in some net cash coming to us.

Again, we haven’t really built ahead and redeployment of that cash to, you know, to necessarily increase earnings going forward. But we obviously you can utilize that cash for a number of different purposes. I would say another example along the same lines is that on again, as I mentioned, some of the resolutions were working on Q2, restructuring of the loan with the existing borrower. We believe in some of the situation we’ve seen and we believe we can restructure the loan, which would potentially include some new cash from the borrower coming into the property, adding to the loan. That would then allow us to then begin to recognize interest on some or all of the existing loan itself. I think those are just three examples of how earnings should be increased going forward upon resolving some of these nonaccrual loans; that’s Omni’s also blends.

I think those are three good examples of how resolving the loans can increase earnings going forward.

Stephen Laws: Appreciate the color. On that basic — you know — them to continue eventually come up with these six new nonaccrual loans on nonaccrual for the entire fourth quarter? Or did they contribute some interest income in the early part of the quarter?

Tae-Sik Yoon: Sure, good question. And I appreciate the detail behind the distinction there. So our policy is that we put a loan on nonaccrual for the entire quarter. So when we talk about the $0.12 impact. That meant that from for the fourth quarter overall for the entire fourth quarter that these six loans did not recognize any interest revenue and interest income for the entirety of the fourth quarter.

Stephen Laws: 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 update us and apologies. I haven’t had a chance to get through the whole filing this morning. And can you update us on where you stand on that, whether you’ll need waivers for lower interest coverage test metrics or how counterparty discussions are going around the developments with these loans?

Tae-Sik Yoon: Sure, Stephen. I just wanted to clarify your question and say interest coverage tests are you talking about these specific loans or the time line? We know that we have in the main role.

Stephen Laws: I can just cover your — your counterparties. I believe it’s typically somewhere between one three and 1.5 interest coverage test with your bank clients, your other financing facilities and any sense debt covenants that need to be considered are discussed around these nonaccrual developments?