Ares Commercial Real Estate: 3 Takeaways From Q1 2023 Earnings

Ares Commercial Real Estate Corporation (NYSE:ACRE) reported earnings on May 2nd, 2023 and sold off on the report. Fears continue to swirl around commercial real estate so many investors were looking for clarity on the state of things at ACRE. Dividend focused investors may be heartened by the headline that not only did the company maintain their $0.33 per share quarterly dividend, but they also announced a $0.02 supplemental dividend. That means the company has paid out a supplemental seven out of the last eight quarters.

Distributable earnings for the same period came in at just $0.27 so it seemed a little odd on the face of it that a supplemental was announced. CEO Bryan Donohoe stated this in the press release, "Our $0.27 of Distributable Earnings per diluted common share, inclusive of the previously announced realized loss of $0.10 per diluted common share, would have resulted in $0.37 per diluted common share without the realized loss, which more than fully covers our regular and supplemental quarterly dividend."

What is being referred to here is a one-time loss upon resolution of a residential loan this quarter. On a move-forward basis, management seems to feel confident that distributable earnings of $0.37 is more representative of the loan portfolio's earnings ability. A further implication here is that management is comfortable with the dividend. Annualized this quarterly dividend totals to $1.32 per share. At the time of writing ACRE traded for $7.85 meaning the stock has projected forward yield of 16.8%.

Let's turn to the earnings call to better contextualize these results.

3 Takeaways from Q1'23 Earnings

Dividend Commitment and Potential Share Buybacks?

Headline results were a GAAP net loss of $6.4 million ($0.12 per share) and distributable earnings of $15.1 million ($0.27 per share). Perhaps more notably management not only reaffirmed commitment to the dividend in the form of a supplemental, they also were resolute when about this on the call. Analyst Rick Shane asked about their capital allocation strategy moving forward which I think helps give some context:

I think you guys have on a relative basis been conservative in terms of your reserves, you've been proactive in terms of managing properties transparent and what you have said to us on a quarterly basis, you're running with low leverage the thing that - I'm having a hard time connecting is the dividend policy and reiterating that today versus buying back shares, implicitly the markets, putting a 15 plus percent cumulative default rate implicitly in your stock price?

Your reserves are conservative and there's a huge gap between those two stocks yielding 18%, if you guys could, if you saw an investment where it was yielding that much because you felt the market was mispricing the credit risk. You would make that investment all day. I just don't understand the - disconnect between the dividend policy and the buyback?"

CFO Tae Sik-Yoon responded to this query by outlining how the company thinks about capital allocation in the current environment. With regard to the dividend they noted, "In evaluating again, the uses of capital, I think our Board has made it very clear that we believe that our shareholders, really do want and expect, and deserve regular predictable, recurring cash dividends. And so as long as we're able to, we believe, earn those dividends through our operations. We believe it is important to maintain that dividend."

It seemed clear that management is at the least committed to their dividend policy this year. What I found notable about the exchange though was reference to potential stock buybacks. Book value per share is $13.15 and with the stock trading at $7.85 that implies a P/B value of 0.60x.

So not only are these shares trading at a discount to book value, each potential stock repurchase would retire the company's requirement to pay the 16.8% implied dividend. They maintain an open $50 million repurchase program from July 2022 of which none has been used. There are 54.7 million common shares outstanding which implies a market capitalization of $429 million. If this program were executed at the current price levels this would reduce the share count by ~11% which I'd say is pretty sizable.

And finally the CFO outright said, "We do think that is a great opportunity to buyback our shares, we would agree." With $154 million cash on hand and a CFO who finds the stock a good option to repurchase I think it stands to reason that some repurchase activity could happen if the loan portfolio holds up.

Improved Liquidity, but No New Originations

Net debt-to-equity was reported at 1.9x at the quarter end which is lowest amongst its peers. Total liquidity inclusive of the $154 million in cash is $225 million. The outstanding balance on the loan portfolio was $2.2 billion meaning liquidity as a percentage of the portfolio is at ~10%.

ACRE already maintained one of the lowest leverage ratios and has continued this trend which should help it navigate any unexpected troubles. It will also likely be needed to help them with another challenge they are facing: a shrinking portfolio.

During this quarter the company made no new loan originations - this was after only making one $56 million office loan last quarter. The outstanding $2.2 billion balance has come down somewhat from the $2.4 billion in 2021 (-8.3%). Management indicated that they believe ongoing opportunities will exist in the CRE space for the foreseeable future. And while the liquidity they've built is defensive, it can also be used opportunistically.

The weighted average effective yield on the portfolio is 9.2% or $202 million annually. Dividends payable for the quarter were $19 million which annualizes to $76 million. What I take this to mean is that there is still a good amount of expected cash-flow cushion covering the dividend. But they will need to turn the tide on the shrinking portfolio eventually.

Increased CECL Reserve and More Troubled Loans

Two loans were resolved in the last quarter. One was a residential loan where they took a $0.10 loss - the one-time loss management noted brought down distributable earnings. While getting the loan resolved is a positive, it ultimately represents a loss-making investment. The second loan that was resolved was an office loan in Chicago which was resolved essentially at par.

What was of note about the Chicago loan is that it seemed to represent more of an outlier conclusion. Management noted on their earnings call that there was underlying land which ultimately held up the value of the loan.

They foreclosed on a mixed-use Florida loan with UPB of $82.7 million due to a maturity default in February 2023. Management expects to take control of this asset in Q2.

A multifamily loan in Washington defaulted also subsequent to the quarter but was not reserved against. This happened due to a partial interest payment and management suggested the stress on the borrower due to rising interest rates but that the asset was performing. Maturity on this $18.7 million loan was extended from March 2023 to September 2023 with Tae-Sik Yoon stating "it's just a bridge to a sale."

It wasn't the only loan to get an extension. Six separate loans set to mature were extended in the quarter representing $319 million on the books (14.5% of total portfolio value).

Lastly, two loans in Chicago were downgraded to a risk rating of 5. The first is a hotel loan worth $35 million which the company set aside $5.6 million CECL for. The other one is an office loan at $56.9 million which they reserved $38.3 million against. Both property sponsors have initiated sales processes for the buildings which may or may not lead to resolution.

All of these details to say: there are still plenty of problem loans coming up. Management is balancing this with their CECL reserves and by actively building out liquidity. I believe these are prudent actions and it remains to be seen what will ensue in CRE.

Readers may have heard of fears around office properties specifically, and we can see this coming up in ACRE's results. Three of the loan extensions, one of their downgrades, and the foreclosure were all office properties. The one positive note was their resolution of the Chicago office loan - yet if we look closer it doesn't bode well for office buildings.

Management stated their takeaway as "the highest and best use for this property was not going to be office moving forward." The property itself had some land which seemed to be what held up the value of the loan. What I take their commentary to mean is that the office building itself is likely to be redeveloped or replaced entirely. And as we can see in the same Chicago market they made a $38 million CECL adjustment for another office loan.

This reinforces the granularity of challenges facing office properties. We can see situations even in the same markets where developers see opportunity for one office property and much less for another. Somewhere in my learning I heard it noted that CRE is in a tactical market phase - loans will need to be analyzed, understood, and interpreted on a case-by-case basis. Plenty of work for the willing analyst.

But I'd agree with the assessment that the U.S. CRE sector is in for some choppy trading as a result of this uncertainty.

ACRE Q1'23 In Summary

Headline news of a maintained dividend shrouded a bit more uncertainty under the surface. Looking through their 10-q shows that management has been active in negotiation regarding a number of loans which may portend problems down the line. But to balance this they've built up a sizable cash position and liquidity to best approach the uncertainty. Their below peer average leverage definitely helps in this tightened credit environment, as well.

Concerns about office properties seemed validated with pressure on the office loans in ACRE's book. But with the company trading off 52-week lows and well below book value, a lot of the bad news may be baked in already. That notwithstanding, office properties are not the only area of concern and a lot of uncertainty remains in the CRE sector overall.

With these results announced it will be really interesting to see how their liquidity is deployed and if hints of a share repurchases lead to actual ones. Finding a way to stabilize the shrinking portfolio while successfully exiting troubled loans will be a clear priority over the next year in my eyes. It's very possible that things could get worse for the stock price here before they get better even if management executes well.

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