Ares Commercial Real Estate Corporation (NYSE:ACRE) Q2 2022 Earnings Conference Call July 29, 2022 12:00 PM ET
John Stilmar – IR
Bryan Donohoe – CEO
Tae-Sik Yoon – CFO
Conference Call Participants
Rick Shane – JPMorgan
Jade Rahmani – KBW
Douglas Harter – Credit Suisse
Good afternoon, and welcome to Ares Commercial Real Estate Corporation’s Conference Call to discuss the company’s Second Quarter 2022 Financial Results. As a reminder, this conference call is being recorded on July 29, 2022.
I’ll now hand the call over to John Stilmar from Investor Relations.
Good afternoon and thank you for joining us on today’s conference call. I am joined today by our CEO, Bryan Donohoe; Tae-Sik Yoon, our CFO; Carl Drake, Head of Public Markets Investor Relations and other members of our team. In addition to our press release and the 10-Q that we filed with the SEC, we have 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 and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the 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, conditions 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 filings.
Ares Commercial Real Estate Corporation assumes no obligation to update any such forward-looking statements. During this call, we’ll refer to certain non-GAAP financial measures. We use these measures of operating performance and 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 and good afternoon, everyone.
This morning, we announced second quarter distributable earnings of $0.38 per share, an increase of 12% from the first quarter, exceeding our combined regular and supplemental dividends paid of $0.35 per share. The growth in our distributable earnings was driven by new investment activity, prepayment fees and the benefits of rising interest rates.
Looking forward, we expect that our earnings potential will continue to benefit from further increases in interest rates due to our floating rate loan portfolio and the hedges we put in place early last year on our liabilities. Let me touch on the changing market conditions and how it influences our investment activity.
Overall property — level fundamentals continue to be stable, although rising interest rates tightened inflation and an uncertain economic backdrop have led to diverging views of property values. This has resulted in the cooling off of commercial real estate transaction activity and has pressured properties that lack inability to increase cash flows.
As market volatility increases and a greater dispersion of expectations for property performance unfolds we believe we are well positioned to benefit with respect to new investments. We believe the sourcing and informational benefits we derive for being a part of the Ares global platform provides even more significant advantages for us in today’s dynamic environment.
During the second quarter, we found investment opportunities with generally more conservative structures and at wider spreads in our target sectors. For the second quarter, we closed $356 million of senior floating rate loan commitments across eight transactions with approximately 80% of the commitments collateralized by multifamily and self-storage properties.
Reflecting the widening spread opportunities we see in the market, spreads on the multifamily loans originated this quarter, for example, were approximately 90 basis points higher than our post-pandemic average spreads for multifamily transactions.
Before turning the call over to Tae-Sik, I want to highlight that our Board recently authorized a new $50 million share buyback plan, providing us the opportunity to repurchase our stock where it is accretive to our earnings and our book value. Given our strong capital position, having this plan in place widens our opportunity set as we seek to continue to prudently invest in a more lender-friendly environment.
I’ll now turn it over to Tae-Sik to walk through our quarterly financial highlights and further details on our portfolio.
Great, thank you, Bryan, and good afternoon, everyone.
This morning, we reported GAAP net income of $10 million or $0.20 per share and distributable earnings of $19.2 million or $0.38 per share. As Bryan discussed, our earnings this quarter were supported by the positive benefits of rising interest rates our liability hedging positions and a net increase of $200 million in our loan portfolio.
In addition, we earned approximately $0.03 per share in the form of fees that were accelerated due to loans that paid off earlier than maturity. We ended the quarter with a portfolio consisting of 99% senior loans and an outstanding principal balance of $2.6 billion across 78 loans.
During the quarter, we collected 99% of our contractual interest due and continue to have only two loans on nonaccrual status, representing less than 2% of our overall portfolio as of June 30, 2022. In terms of credit quality metrics, the weighted average risk rating for the portfolio increased slightly to 2.8% from 2.7% last quarter, but it continues to be below our 2021 quarterly average of 2.9%. This modest change primarily reflects a shift of five loans from a risk rating of two to a risk rating of three due to our outlook and select, business plans on several performing properties.
Importantly, there were no additions to our four risk-rated loans, and we continue to have no risk-rated five loans. In terms of CECL, we increased our general reserve by $7.8 million to $32.4 million, driven by a change in the outlook of a few properties in select markets and a $3.3 million increase in the net portfolio growth in the quarter.
Turning to our capitalization and liquidity, our borrowing base remains highly diversified across eight various financing sources. And importantly, none of these financing sources have spread-based mark-to-market provisions. We are also in a very strong capital position with approximately $190 million of available capital as of July 28.
Our strong capital position is supported by the issuance of 7 million common shares raising just over $100 million of common equity at a premium to book value during the second quarter. This healthy level of available capital should benefit us as we selectively invest in an increasingly attractive spread opportunity and maintain a significant level of protection from unexpected credit losses.
Let me now provide an update on our portfolio positioning and impactful changes in short-term interest rates on the future earnings potential of our company. 98% of our portfolio, as measured by unpaid principal balance is comprised of floating rate loans indexed to either one month LIBOR or SOFR, resulting in our portfolio — being positioned to benefit from further increases in the respective indices.
We also continue to match funds our assets and liabilities and hedged a significant portion of our floating rate debt through interest rate swaps to fix the interest rates on some of our longer-term liabilities. As a result, our company’s future net interest income is positioned to benefit from additional increases in market rates. Currently, over 90% of Ares’ loans are sensitive to further increases interest rates as loans and LIBOR floors have paid off or current LIBOR rates are above most labor floors.
However, as we have put in place fixed rate financing on our recent $150 million term loan and in 2021, entered into a hedge position that currently has a notional balance of over $500 million and locks in LIBOR at 21 basis points only about 2/3rd of our liabilities are sensitive to changes in LIBOR, putting the company in a very positive position to benefit from further increases in interest rate.
So for example, on a pro forma basis, if hypothetically, LIBOR was 100 basis points higher than actual June 30, 2022 levels and all other aspects of our portfolio remain the same as of the same date our annual distributable earnings would have been higher by approximately $12 million or $0.24 per share.
And finally, this morning, we announced a third quarter 2022 regular dividend of $0.33 per common share as well as a continuation of our supplemental quarterly dividend of $0.02 per common share. Bolstered by the tailwinds of rising rates and our proactive hedging, we continue to believe our distributable earnings will meet or exceed the combined regular and supplemental dividend for the year.
So with that, let me turn the call back over to Bryan for some closing remarks.
That’s great, thanks so much, Tae-Sik.
In closing, we believe Ares commercial real estate remains well positioned to navigate the changing economic landscape. Our balance sheet is in great shape with low leverage, no spread-based mark-to-market sources of financing and a robust level of available capital to invest in higher-yielding opportunities with better structural terms.
Further, supported by the potential benefits in rising rates, we believe the future earnings power of the company is very strong. That said, we recognize the challenges that rising rates and future economic uncertainty will have on certain real estate properties. Consistent with our disciplined approach and credit-first culture, we will remain highly selective and be measured in our deployment of capital.
Before we take questions, we want to sincerely thank our team for their hard work this quarter. I also want to highlight the team’s commitment to our collective goal at areas of investing in our communities. This quarter, the team donated a portion of the earned incentive fee to the Ares Charitable Foundation, which promotes global health, entrepreneurship and education across our communities. We hope and believe this is the first of many contributions to the cause. I also want to thank all of our shareholders for their continued support of our company.
And with that, I’ll ask the operator to open the line for questions.
[Operator Instructions] And our first question is from the line of Rick Shane of JPMorgan. Your line is now open. Please proceed.
Terrific. Thanks everybody for taking my question. Look, you guys did a good job highlighting the asset sensitivity and the advantages of the hedge. You also talked about spread widening and what’s happening marginally in terms of the portfolio. The one thing I’d just like to think about in terms of those two factors is how does that impact duration of the assets? How do you think about new opportunities presumably, there’s a little bit more pressure so you get to be a little bit more selective, but relate that to repayments and balance sheet capacity, please?
Absolutely, Rick and it’s a good one. I’d say when we enter periods like this where there’s a little bit less rhythm to the financing or sale process within our industry. One of the things we focus on is just a lot more dialogue. I mean [Joel] and the team and asset management are in constant dialogue with these borrowers in normal course. But we’ll try to map a little bit more subjectively through conversations when we think those deals will get consummated.
I think it’s fair to say it’s not — it’s clearly not as linear as in a residential mortgage book, but when rates go up and there’s a little bit of duress. We do expect there to be some more duration on individual assets or really, I should say, collectively, throughout the portfolio, there’ll be more duration broadly, but individual assets will still behave based on their business plan. And what we see generally is, if an investor an underlying real estate equity owner has decided to sell or refinance that asset, that’s put in motion fairly well in advance.
And again, those time lines might get extended. But we’ll manage the conversation with that borrower as best we can and then position the origination team to utilize the capital if that’s when it comes back in — in that normal course financing and sale process?
Got it okay. And then the other question and you dovetail this actually quite nicely. In your conversation with sponsors, we’re entering a period of greater uncertainty. And when we — if we roll back the clock to sort of early 2020, we saw what I would describe as fairly idiosyncratic behavior by sponsors in terms of their willingness to provide additional capital or to walk away from different properties? I’m curious how you — in your conversations with sponsors, how they feel about their ongoing commitments to property? Do they have liquidity are they concerned in the way that they were 2-plus years ago or are they going to take longer views?
I would imagine that throughout the broader industry, you get a lot of different answers. I think this reset that we’re seeing is a little more there’s, unique features to it. What happened in March, April of ’20 was just so dramatic in terms of it being something that none of us had experienced in our lifetimes and also the velocity of change, right? It was Tuesday, you’re in the office and Friday you’re at home for the foreseeable future.
And I think that level of collective ignorance about what the forward cycle looked like made behavior a little bit more difficult to predict. In this case, I think the world is recognizing uniformly rising rates and trying to position themselves to defensively get through those rising rates. So I think it continues to run the gamut. However, if you go through the quantitative changes in the curve as well as spreads, right.
We’re talking about, again, just quantitatively all things being equal in terms of the business plan, somewhere 8% to 10%-ish change in values based on just that forward curve. So I think that’s not all that dramatic of a move. And I think most borrowers are in a position to withstand that type of move. Most importantly though, from an offense positioning, as Tae-Sik mentioned on the call, we have $190 million of capital available to take advantage of that reset and values, the reset in the forward curve as well as higher spreads.
And I don’t want it to be lost that – we mentioned on the prepared remarks, but the change in the structure is significantly advantageous in favor of the lender today. And that’s most pronounced and the spread changes are most pronounced at the top of the curve. So I think what would be AAA-type risk having seen the widest increase in coupon. So I think we feel pretty good about the forward pipeline and what’s available to us.
Bryan and to your comment about lots of different answers, we’re asking the question a lot of different times and you are absolutely right, we’re getting different answers. So I appreciate the perspective.
And our next question is from the line of Jade Rahmani of KBW. Your line is now open.
Thank you very much. One of the commercial real estate brokers earlier today said in contrast with past cycles where this bid-ask spread, this adjustment in the market took several quarters, four quarters, maybe longer, this cycle feels like it could unfold faster than that. And indeed, compared to conversations a couple of months ago, things do feel like they’re already perhaps starting to transact and perhaps the treasury yields are an indicator of? I don’t know what term you want to use, soft-landing or something of that nature. But would you agree with that or do you believe that the future is yet unknown and there’s no way to predict that. So maybe it will take longer than, say, one to two quarters?
It’s a good question, Jade I appreciate it. I’d say a couple of things. In normal course, the information flows we receive being part of the Ares platform will be more of an inducement or give you a better advantage to consummate a transaction. Over the last six months, we’ve narrowed our focus in terms of where we’ve deployed capital and the way we’ve approached transactions because of the same.
So you can say it’s kind of reversed course where the information allowed us to avoid some things that other market participants we’re still participating in. To the extent, I’m echoing what your broker clients said this morning, I’d say look, the broad-based change in rates, right and you’re seeing 30 basis point-type movements within the course of a week in the 10-year, that was something that just was so transparent and readily available information.
So broadly throughout the real estate market and certainly, the financing market that you’d be hard-pressed not to change your expectations or your belief in underlying property values. That cuts across a little bit the demand side that we’re continuing to see in the industrial sector as well as apartment leasing where rents are continuing to escalate, and there’s depth of tenant demand there. So I think what we’re all grappling with is these fundamentals that remain fairly sound with changes in the capital markets that are absolutely impacting values.
And there’s certainly more differentiation in the market, both equity and debt in terms of favoring more institutional borrowers and favoring different parts of the credit curve. So I would tend to agree with your reference that what’s occurred has happened much more quickly than in prior down cycles.
And based on our conversations, it does confirm the solid demand trend that you cited, particularly in multifamily. And it seems that the capital markets may have begun to adjust, but there’s still very strong tenant demand out there. I know we’ve spoken about housing in the past and the turmoil and the housing market, potential home price declines? Do you view multifamily as a beneficiary of that or not necessarily the case? Do you expect rent growth to moderate and is that a sector you’re continuing to favor in terms of capital allocation?
Yes certainly, continuing to favor industrial and multifamily. That’s where we’ve focused our efforts both in our debt book as well as equity book for various reasons. In terms of the apartment market as I said, rents continue to grow. What we’re focused on is a couple of things.
One, the strength of the consumer, right when you have gas prices up 100-plus percent plus rents that in certain markets have escalated beyond what we would call the natural course, kind of just the level of scarcity has allowed for rents in certain areas like Phoenix to grow just so exponentially that it’s tough to get the logic behind it. So we’re avoiding certain markets because of that rapid growth and cognizant of the stress at the consumer level.
So we’re looking at things like bad debt growing in certain rentals and looking out for that as kind of a scenario in coal mine, if you will. And again, I’d bring it back Jade, to what we said regarding the advantageous structures available. We can target opportunities where the capital structure is just lower leverage than it has been over the last few quarters and structural features such as cash management.
Again, that should continue to delever our capital structure to the extent that rent increases aren’t available to the equity side as they may have anticipated. So you’ll still see us active in the space. But I think across the board, we and certain of our peers are just going to be more measured in the way we go about it.
Appreciate the comments. And I think the point about structure – loan structure is very important because everyone is so focused on spread and takes directionality there, but structure is a tool in your toolkit to protect capital.
[Operator Instructions] And our next question is from the line of Douglas Harter of Credit Suisse. Your line is now open.
Thanks. I’m hoping you could talk a little bit about the dividend and the structure of still having a supplemental dividend kind of given the strength of earnings you’ve seen and the coming benefit from rising rates?
Absolutely let me — I’ll start and then I’ll turn it over to Tae-Sik as well. I think, clearly, it’s something we consider because of exactly what you mentioned, the strength of earnings and the benefits that we’re seeing in terms of rhythm of repayments as well as just the forward curve being supportive of us plus the hedging that we strategically put in place 12-odd months ago. Counter to that, we’re just cognizant of the dynamic in the market and the uncertainty that’s coming with that.
So if you had all of the factors that I mentioned at the outset here, in a positive way, without the instability caused by the Fed movements that doesn’t feel like there’s end in sight as of yet. I think we might be having a different conversation. So I just want to give a little bit of context in terms of how we’re thinking about it. But Tae-Sik, I’ll let you answer a little bit more specifically.
Yes as Bryan mentioned, we obviously instituted the supplemental dividend earlier last year as a way to share the benefits of the LIBOR floors, as we mentioned. As we said previously, LIBOR floors are not a permanent asset, but certainly one that we felt was going to provide excess earnings for a period of time and we thought the best way to match on that was to come in the form of the supplemental dividend.
Today, as I mentioned in our opening remarks, with LIBOR up significantly, LIBOR up significantly up to about 2%, 3%, even almost 2.4%, most of our LIBOR floors have now run off. But fortunately, last year, we also put in place our interest rate hedge. So I would tell you, currently, we’re sort of enjoying the benefits of not the floors, but really the interest rate hedge.
So the $0.02 supplemental dividend now kind of reflects the so-called excess earnings that we’re enjoying because of the interest rate hedge we put in place in our liabilities because our floors are not as much in the money. The good news is, as we said, more than 90% of our assets today are sensitive to further rises in interest rates. So we’re benefiting from rising interest rates. We’re benefiting from the interest rate hedges. And that’s really what’s reflective of that supplemental dividend.
As Bryan said, I think the company and the Board, in particular, will take all of that into consideration, along with continued volatility in the market and really determine whether that $0.02 should continue as a supplemental dividend, whether that $0.02 supplement can be converted to more of a permanent dividend or otherwise. But I think that’s really our thinking about the $0.33 regular dividend and the $0.02 supplemental dividend.
Really appreciate that.
And we have no further questions at this time. So it’s my pleasure to hand back over to Bryan Donohoe for any closing remarks.
That’s great. I just want to thank everybody for their time today. We certainly appreciate your continued support of Ares Commercial Real Estate, and we hope you have a great rest of the summer and look forward to speaking with you again on our next earnings call this fall. Thank you again.
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 August 26, 2022, to domestic callers by calling 1 (866) 813-9403 and international quarters by calling +44 (204) 525-0658. For all replays, please reference the conference number 984-066. An archived replay will also be available on the webcast link located on the homepage of the Investor Resources section of our website. You may now disconnect your lines.