Ares Commercial Real Estate Corporation — Q2 2023 Form 10-Q Summary
Business context and reporting period
Ares Commercial Real Estate Corporation is an externally managed REIT and specialty finance company focused primarily on originating and investing in commercial real estate loans and related investments. The company operates as one segment and is managed by Ares Commercial Real Estate Management LLC, an affiliate of Ares Management Corporation.
This filing covers the quarter and six months ended June 30, 2023, compared primarily with the corresponding 2022 periods. The interim financial statements are unaudited and prepared under U.S. GAAP.
Key financial metrics
| Metric | Three months ended June 30, 2023 | Six months ended June 30, 2023 |
|---|---|---|
| Total revenue | $25.0 million | $51.5 million |
| Net interest margin | $25.0 million | $51.5 million |
| Total expenses | $7.1 million | $13.3 million |
| CECL provision | $20.1 million | $41.1 million |
| Realized losses on loans sold | — | $5.6 million |
| Net income attributable to common stockholders | $(2.2) million | $(8.6) million |
| Diluted earnings per share | $(0.04) | $(0.16) |
| Dividends declared per share | $0.35 | $0.70 |
Interest income increased to $51.9 million in the quarter and $101.4 million for the first six months, but interest expense increased substantially to $27.0 million and $50.0 million, respectively. The filing does not provide a single reported net-interest margin percentage; based on reported figures, net interest margin was approximately 100% of total revenue because total revenue consisted primarily of net interest margin.
At June 30, 2023, loans held for investment had a carrying amount of $2.23 billion and outstanding principal of $2.25 billion. The portfolio comprised 53 loans, with a weighted-average unleveraged effective yield of 8.7% and a weighted-average remaining life of 1.3 years. Approximately 71.2% of loans had SOFR floors.
Cash and cash equivalents were $142.6 million. Total assets were $2.40 billion, total liabilities were $1.71 billion, and stockholders’ equity was $691.2 million. As of August 1, 2023, management reported approximately $193 million of liquidity, including $118 million of unrestricted cash and $75 million of available borrowing capacity.
Total financing-agreement debt, excluding CLO securitization debt, was $936.3 million at June 30, 2023, against total commitments of $1.535 billion. CLO securitization debt was $735.1 million. Total liabilities therefore included approximately $1.67 billion of these financing obligations. The company stated that it was in compliance with all financial covenants at June 30, 2023.
Net cash provided by operating activities was $23.2 million. Investing activities provided $89.3 million, primarily reflecting loan repayments and loan-sale proceeds exceeding new loan funding. Financing activities used $111.1 million, principally for debt repayments, dividends and share repurchases. Cash increased by $1.3 million during the first six months.
Material changes versus prior comparable periods
- Net income declined from $10.0 million to a $2.2 million net loss in the second quarter, and from $26.2 million to an $8.6 million net loss for the first six months.
- Net interest margin was essentially flat year over year in the second quarter, despite higher interest income, because interest expense approximately doubled. For the first six months, net interest margin increased from $46.5 million to $51.5 million.
- The CECL provision increased from $7.8 million to $20.1 million in the quarter and from $7.2 million to $41.1 million for the first six months.
- The CECL reserve for funded loan balances increased from $66.0 million at December 31, 2022 to $108.1 million at June 30, 2023. Including the reserve for unfunded commitments, total CECL reserves were $112.5 million, or 466 basis points of total loan commitments.
- Five loans with a carrying value of $170.8 million were on non-accrual status at June 30, 2023, compared with three loans totaling $99.1 million at December 31, 2022.
- Two loans were downgraded to risk rating 5, and the company recorded specific CECL reserves of $42.1 million on an Illinois office loan and $5.9 million on an Illinois hotel loan.
- The company sold two loans during the first six months. One maturity-defaulted loan sale generated a realized loss of $5.6 million; the other sale was completed at carrying value.
- Loans held for investment declined from $2.26 billion at year-end 2022 to $2.23 billion at June 30, 2023. The company funded approximately $106.8 million, received approximately $97.2 million of principal repayments and sold loans with approximately $41.5 million of outstanding principal.
- Stockholders’ equity declined from $747.5 million to $691.2 million, reflecting net losses, dividends, other comprehensive losses and a $4.6 million repurchase of 535,965 shares at an average price of $8.58 per share.
- Real estate-owned revenue, expenses and gains were absent in 2023 because the hotel property previously classified as real estate owned was sold in March 2022.
Guidance, outlook, commentary and risks
Management expects its primary sources of cash to be sufficient to fund operating activities and cash commitments for at least the next 12 months and thereafter for the foreseeable future. However, the company cautioned that borrower payment delays, loan maturity defaults, margin calls, covenant breaches and limited access to financing could materially affect liquidity.
Management described continued pressure on commercial real estate from high interest rates, inflation, tighter bank lending standards, market illiquidity and uncertainty in regional banking markets. Office properties face additional pressure from remote work, higher vacancy rates and higher operating or reconfiguration costs. The company noted that unspent capital targeting commercial real estate could partially support property values and transaction activity.
The company expects leverage generally not to exceed 4.5 times debt to equity under current conditions, although its charter and bylaws do not impose a leverage limit. The company primarily uses floating-rate assets and index-matched floating-rate liabilities, supplemented by derivatives. Its sensitivity analysis estimated that a 100-basis-point increase in 30-day SOFR would increase annual net income by approximately $6.0 million, while a 50-basis-point increase would increase annual net income by approximately $3.0 million. The filing presents an estimated $(15.2) million net-income sensitivity at SOFR of 0 basis points.
The portfolio includes several maturity-defaulted, non-accrual or otherwise higher-risk loans. A Florida mixed-use loan with a $82.7 million outstanding principal balance was in maturity default, with consensual foreclosure expected to result in acquisition of the property in the third quarter of 2023. Other loans were extended or modified, including loans secured by office, mixed-use, hotel and multifamily properties.
The company declared a regular third-quarter 2023 dividend of $0.33 per share, payable October 17, 2023 to stockholders of record September 29, 2023. Management also stated that dividends could be reduced or suspended if required by liquidity, financing or REIT-related considerations.
Subsequent to quarter-end, the Morgan Stanley Facility was amended to extend its initial maturity date to July 16, 2025, subject to conditions and a potential additional extension. The company renewed its $50 million share repurchase authorization through July 31, 2024.
The filing reports no material pending legal proceedings, no material changes to previously disclosed risk factors and effective disclosure controls as of June 30, 2023.
Important facts for investors to verify
- Whether the elevated CECL reserve and specific reserves for risk-rated 5 loans are sufficient given property values, borrower performance and refinancing conditions.
- The status and ultimate recovery prospects of the five non-accrual loans, maturity-defaulted loans and the expected Florida foreclosure.
- Near-term refinancing, extension and margin-call risk across the Morgan Stanley, CNB, MetLife and other secured funding facilities.
- Whether liquidity of approximately $193 million as of August 1, 2023 remains adequate after unfunded commitments of $161.1 million, dividends, debt service and potential collateral requirements.
- The sustainability of the $0.33 quarterly dividend relative to recurring earnings, cash flow, CECL provisioning and REIT distribution requirements.
- The impact of continued high SOFR, office-property weakness, regional bank stress and potential commercial real estate valuation declines.
- The company’s exposure to consolidated CLO first-loss positions and the effect of overcollateralization tests on cash distributions from the CLO structures.