Ares Commercial Real Estate: Loan Losses Expected To Soar As Property LTVs Rise

The commercial real estate market activity is likely one of the most significant trends of 2023. After many years of decent returns, commercial property prices have begun to decline quickly. Nationally, commercial property prices are currently down around 17% from their 2021 peak value; however, the impact is most extreme for office properties and less for other segments. US Commercial real estate transaction volumes have declined by 50% to 70% from last year's levels, indicating the market is freezing. Sales of commercial mortgage bonds crashed by around 85% YoY, with delinquencies beginning to surge over the past quarter.

It is clearly a very poor time to be in the commercial property lending business. Mortgage REITs focused on commercial property loans, such as Ares Commercial Real Estate (NYSE:ACRE), have lost considerable value. ACRE is down by around 14% over the past year and nearly 40% below its pre-COVID value. Commercial property lenders' risks differ dramatically from those of residential lenders, such as Orchid Island (ORC). Many commercial lenders focus primarily on short-term variable rate loans, which have no direct interest rate risk (which is immense for residential lenders) but much higher credit risk (which is low for residential lenders).

Commercial property prices have had much greater strains than residential properties. Commercial property lenders have fared better than residential property lenders over the past eighteen months due to their lower interest rate exposures. As mortgage rates peak (which is not guaranteed), I expect residential lenders to stabilize while commercial lenders like Ares face greater delinquency-related strains.

ACRE attracts many investors due to its 13.7% forward dividend yield, making it one of the highest-yielding assets, excluding those with low market capitalizations. Its yield is so high that ACRE's total return, including dividend reinvestment, has been flat since 2020 despite a nearly 40% decline in its price. See below:

While its dividend record is impressive, ACRE has experienced a lot of volatility for delivering no positive returns to investors over this period. Further, its losses have seemingly accelerated over the past year despite a considerable rebound over the summer. Should that rebound reverse, ACRE may quickly decline by ~15% as it falls back to its earlier support level. As such, it seems reasonable to take a closer look at the investment and its economic risk exposures.

A Look at Credit Risk in Commercial Property

Ares' portfolio is primarily interest-only variable-rate senior loans on commercial properties. Most of those loans have maturity dates under three years, so borrowers must successfully refinance to repay Ares. Of course, should property prices decline, higher loan-to-value ratios will make refinancing more difficult for borrowers, creating loan loss risks for Ares. Around 38% of its portfolio is parked in offices, its largest overall segment and the most at-risk segment today. The rest of its portfolio is more diversified between other components (multifamily, industrial, etc.) with no solid geographical concentration.

Today, Ares aims to purchase loans at discounted prices from banks that are retreating from the segment. This is an exciting strategy because many regional banks with a high commercial property loan concentration face liquidity issues associated with declining deposits. Since many investors are concerned about bank risks related to commercial properties, banks are incentivized to sell commercial property loans, even if they're relatively safe, to regain public confidence. This situation creates a value opportunity for Ares as it can buy these assets at higher yields than are normal in originations.

Commercial property delinquencies are starting to tick up, but they're not yet too high. That said, due to the surge in property prices in 2021, US bank exposure to commercial real estate loans rose dramatically as property owners refinanced at higher prices. However, the YoY growth of commercial property loans is nearly zero today, indicating banks do not want to increase exposure to these assets. See below:

While commercial property prices are in free-fall (depending on segment), commercial property lending has not yet experienced tremendous difficulty as delinquency rates are still not too high. Of course, that figure seems to vary with data measurements. Other measures, such as the overall CMBS delinquency rate, are as high as 4.4% today for all segments. Office CMBS delinquencies are over 5%, a 20-month high reaching the 2020 shock.

Commercial property's core issue is the increase in interest rates, particularly in interest rates after inflation, as measured by Treasury inflation-indexed interest rates. As detailed in many of my articles, this figure is significant for commercial properties because their capitalization rate valuations are closely tied to it in the long run. Inflation-indexed rates (or "real rates") are more important than interest rates because most commercial properties see their net operating incomes rise with inflation. Of course, as I recently discussed regarding REITs, trends such as work-from-home and a lack of household discretionary spending capacity are causing many properties to see below-inflation NOI growth, causing those properties to lose value independent of changes in real interest rates.

Still, the massive increase in real interest rates, particularly the most recent increase, will profoundly impact commercial property prices, creating strains for CMBS assets. See below:

The overall increase in 10-year real interest rates since 2021 is now up to nearly 3.3%, one of the fastest increases ever. All capitalization rates fell to around 5.4% at the end of 2021, coinciding with the record-low level for US real interest rates. From 2020 to 2021, capitalization rates fell from 6.4% to 5.4%, just as real rates fell from ~0% to -1%, validating the 1-to-1 relationship.

Considering the relationship between real rates and capitalization rates, cap rates may rise to 8.7% (3.3% higher) if real interest rates remain where they are today over the coming year or two. This would result in a ~38% total decrease in property prices, given no change in NOI. That is a reasonable assumption, considering that rents stagnate today while property overhead costs rise with (or above) inflation. I do not expect property prices to fully react to these changes so quickly because transaction volumes are so low today. That said, we've already seen a 17% decline, nearly half of the total loss I expect in the commercial property market.

Ares does not publish the LTV values of its loans, likely because it is purchasing them at a discount. Most commercial loans have LTVs around 70% at origination, so the property price shock should push LTVs up to 90% for most outstanding loans and over 100% for some. Depending on the discounts Ares receives, this could be a massive issue for the company as its borrowers struggle to refinance, given that most lenders will not lend at LTVs over 80%.

I believe the commercial property market is in the early phase of the rise in delinquencies associated with failed refinancing due to the huge increase in LTVs. That said, Ares has already seen its allowance for loan losses soar considerably to $108M, far above the 2020 peak level. Currently, this equates to 15.6% of its book value. See below:

Importantly, ACRE's book value already accounts for loan losses. The existing allowance for loan losses has already reduced its value, so the direct ratio of the two is not necessarily crucial. That said, it does illustrate the magnitude of risk. Loan losses have risen by around 5% of book value each quarter, indicating a negative loss trend for ACRE's importance. Further, allowance for loan losses accounts for relatively immediate loan defaults; defaults usually occur long after strains begin to exist, so I believe it is likely that its loan loss allowance will continue to rise at a fast pace.

Default risks in commercial real estate should not be overlooked. Most of Ares' portfolio has unlevered yields of ~9% or around 4% over the short-term borrowing rate. That spread is typical of the sector and implies that its loans are about as risky as most commercial properties. The company's portfolio is very short-term, which is a significant issue because interest rates will likely remain very high by the time its borrowers need to refinance. If its maturity lengths were longer, then we could expect interest rates to normalize (aiding property prices) by the time of refinancing.

At this point, it is too early to give a clear outlook for the total expected loan loss, but I would not be surprised to see losses eventually consume up to 40% or more of ACRE's existing book value. The company's debt-to-equity is just over 2X today, so a 40% decline in its equity requires a ~11.5% decline in its asset value. That is certainly not a small amount, but I do not believe it is unreasonable given the 17% existing decline in commercial property values and an expected total decline of over 30%, likely causing default issues with poor collateral. The significant determining variable will be changes in the economic outlook and interest rates, with stagflation (sustained rates and a weak economy) being the worst overall outcome, harming property NOIs while aiding higher capitalization rates.

The Bottom Line

For the most part, investors should do their best to overlook dividend yields and income-related valuation metrics for mortgage REITs. This is important because mortgage REITs like ACRE can quickly boost their incomes by increasing their leverage; however, doing so creates immense risk for equity investors. Thus, price-to-book is undoubtedly the best valuation measurement for mortgage REITs with significant short-term loans because its book value should be close to its liquidation value. Currently, ACRE trades at a 24% discount to its book, usually trading at its book value before 2020. See below:

ACRE trades at a significant discount to its tangible book value, allowing for a relatively substantial increase in loan losses before it would be back above its book value. However, we must remember that interest rates and NOI strains (in some segments) are the greatest that the commercial property market has ever seen in recent history. Commercial property debt is also the highest it has ever been. Thus, this unprecedented situation could easily create loan losses much more significant than those seen in 2008.

Is ACRE particularly overvalued? Based on its price-to-book ratio, I do not believe ACRE is overvalued, as it is priced for a relatively significant correction in the commercial property lending market. That said, I think that total losses will be worse than it is currently pricing for because the most recent spike in real interest rates should create added downward pressure on commercial property prices over the next year. If real interest rates had not spiked over recent months, I would not be too bearish on ACRE today. However, given its price rose while real rates increased, I firmly believe it does not account for the likely negative impact of higher real rates on property borrowers refinancing abilities. Thus, I am bearish on ACRE, but it is not so overvalued that I would bet against it.