Ares Commercial Real Estate Corporation: Q2 2017 Form 10-Q Summary
Business context and reporting period
Ares Commercial Real Estate Corporation is an externally managed specialty finance company focused on originating and investing in commercial real estate loans and related investments. The company elected REIT status and is managed by Ares Commercial Real Estate Management LLC, an Ares Management subsidiary. This unaudited Form 10-Q covers the three and six months ended June 30, 2017.
The company completed the sale of its mortgage banking subsidiary, ACRE Capital, on September 30, 2016, for approximately $93 million. Prior-period mortgage banking results are presented as discontinued operations.
Financial performance and key metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Interest income | $22.6 million | $18.9 million | $43.8 million | $37.7 million |
| Interest expense | $12.2 million | $8.4 million | $23.0 million | $16.9 million |
| Net interest margin | $10.4 million | $10.5 million | $20.8 million | $20.7 million |
| Total expenses | $3.7 million | $3.2 million | $7.5 million | $6.7 million |
| Net income from continuing operations | $6.7 million | $7.3 million | $13.2 million | $14.1 million |
| Net income attributable to common stockholders | $6.7 million | $8.7 million | $13.2 million | $13.8 million |
| Diluted earnings per share | $0.24 | $0.31 | $0.46 | $0.48 |
| Dividends declared per share | $0.27 | $0.26 | $0.54 | $0.52 |
Q2 net interest margin represented approximately 46% of interest income, compared with approximately 56% in the prior-year quarter. The decline primarily reflected higher borrowing costs as the portfolio and average borrowings expanded.
At June 30, 2017, total assets were $1.66 billion, including $1.64 billion of loans held for investment. Stockholders’ equity was $417.0 million. Cash and cash equivalents were $5.7 million, with restricted cash of $0.4 million. Total debt and secured financing reported on the balance sheet included $809.7 million of secured funding agreements, $151.1 million of secured term debt and $270.8 million of consolidated CLO debt.
The investment portfolio consisted of 38 loans with $1.65 billion of outstanding principal and a $1.64 billion carrying amount. Senior mortgage loans represented $1.53 billion of carrying value; subordinated debt and preferred equity represented $112.3 million. The portfolio had a weighted average minimum borrowing spread of 5.2%, weighted average unleveraged effective yield of 6.4% and weighted average remaining life of approximately two years. Approximately 89% of loans had LIBOR floors.
Cash flow, liquidity and leverage
| Cash flow metric | Six months 2017 | Six months 2016 |
|---|---|---|
| Cash provided by operating activities | $13.0 million | $33.4 million |
| Cash used in investing activities | $(324.9) million | $33.6 million provided |
| Cash provided by financing activities | $270.3 million | $(69.7) million |
| Change in cash | $(41.5) million | $(2.7) million |
Investing cash outflows reflected $421.8 million of loan fundings, partially offset by principal repayments. Financing inflows included $376.1 million of secured-funding proceeds and $272.9 million of CLO debt issuance, partially offset by $347.1 million of secured-funding repayments and $15.1 million of dividends paid.
Total commitments under the company’s financing agreements were approximately $1.59 billion, with $964.7 million outstanding at June 30, 2017. The company also had $97.5 million of unfunded loan commitments. Management reported compliance with all financing covenants. The company’s stated leverage policy is generally not to exceed a 4-to-1 debt-to-equity ratio, although it expected leverage for particular investments to vary.
Material changes versus the prior comparable period
- Loans held for investment increased from $1.31 billion at December 31, 2016 to $1.64 billion at June 30, 2017, driven by new originations and fundings.
- Interest income increased 20% year over year in Q2 and 16% for the first six months, but higher interest expense largely offset the benefit, leaving net interest margin broadly flat.
- Q2 net income attributable to common stockholders decreased 23% year over year, primarily because the prior-year period included $2.7 million of discontinued-operation income and $1.3 million attributable to non-controlling interests; Q2 2017 had no discontinued-operation income.
- Operating expenses increased 14% in Q2 and 12% for the first six months. Management and incentive fees increased, including $113,000 of Q2 incentive fees and $381,000 for the six-month period, compared with none in the prior-year periods.
- The company launched and consolidated a CLO securitization in March 2017, issuing approximately $308.8 million of notes and retaining approximately $68.2 million of notes and preferred equity. The consolidated CLO debt balance was $270.8 million at quarter-end.
- The Wells Fargo facility was increased from $325 million to $500 million, and the U.S. Bank facility was increased from $125 million to approximately $186 million. The BAML facility’s borrowing period and final maturity terms were also extended.
- The company’s ACRC KA investment was repaid in full in January 2017, eliminating the related third-party non-controlling interest by June 30, 2017.
Guidance, outlook, risks and unusual items
No formal earnings guidance was provided. As of August 2, 2017, management reported approximately $111 million of cash or expected available undrawn financing capacity. After reserving $10 million for liquidity requirements, management estimated approximately $101 million available for new loans, existing commitments and general purposes. Assuming 2.5-to-1 leverage, management estimated capacity to fund approximately $350 million of additional senior loans. Existing unfunded loan commitments were approximately $103 million as of that date.
Management declared a $0.27 per-share dividend for the third quarter of 2017, payable October 16, 2017. The company expects to distribute at least 90% of REIT taxable income, but distributions remain subject to operating needs, debt service, taxable income and available cash.
- Credit risk is concentrated in commercial real estate collateral and borrower performance. The filing states that all loans were paying according to contractual terms and that no impairment charges were recorded through June 30, 2017.
- Interest-rate risk remains significant. Most assets and borrowings are floating rate and index-matched, but differences in floors, caps and repricing may compress net interest margin. Management estimated that a 100-basis-point increase in average 30-day LIBOR would increase net interest margin by approximately $0.9 million for the quarter and $1.8 million for the six months, based on the disclosed portfolio.
- Liquidity and refinancing risk could arise from secured-funding maturities, collateral requirements, lender discretion, market disruptions or inability to extend or replace facilities.
- The CLO’s senior noteholders receive principal repayments before the company receives proceeds from the securitized loans. The company’s maximum stated exposure to loss on the consolidated CLO was $68.2 million.
- The company had $97.5 million of unfunded investment commitments at quarter-end and approximately $103 million as of August 2, 2017.
- Subsequent to quarter-end, the company originated loans with approximately $13.4 million and $38.4 million of initial outstanding principal on multifamily and student-housing properties, respectively.
Important facts for investors to verify
- Reconcile portfolio growth and new originations with available financing capacity, unfunded commitments and cash liquidity.
- Review the maturity, extension rights, advance rates, collateral requirements and covenant tests for each secured financing facility.
- Assess the effect of rising or falling LIBOR on asset yields, borrowing costs, floors, caps and net interest margin.
- Evaluate credit quality, property-level performance, loan-to-value metrics and maturity concentrations; the filing does not provide a single portfolio-wide loan-to-value figure in the provided text.
- Understand the CLO’s first-loss exposure, sequential repayment structure and the company’s retained subordinate interests.
- Monitor management and incentive fees, related-party expense reimbursements and the May 2018 expiration and renewal terms of the external management agreement.
- Confirm the sustainability of the $0.27 per-share dividend against REIT taxable income, cash flow, liquidity reserves and debt-service requirements.