Ares Commercial Real Estate Corporation — Q3 2015 Form 10-Q Summary
Business context and reporting period
ACRE is a specialty finance company operating through two segments: principal lending, which originates and holds commercial real estate debt investments, and mortgage banking, which originates, sells and services primarily multifamily and senior-living loans through ACRE Capital. The company is externally managed by Ares Commercial Real Estate Management LLC and has elected REIT status.
This unaudited Form 10-Q covers the three and nine months ended September 30, 2015, compared with the corresponding 2014 periods. ACRE had 28,609,650 common shares outstanding as of November 3, 2015.
Financial performance and key metrics
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Total revenue | $23.9 million | $13.2 million | $64.5 million | $44.4 million |
| Net interest margin | $12.2 million | $8.4 million | $37.5 million | $26.2 million |
| Mortgage banking revenue | $11.7 million | $4.8 million | $26.9 million | $17.5 million |
| Income before income taxes | $12.9 million | $2.9 million | $33.6 million | $13.7 million |
| Net income attributable to common stockholders | $9.4 million | $4.1 million | $25.4 million | $15.5 million |
| Basic and diluted EPS | $0.33 | $0.14 | $0.89 | $0.54 |
| Dividends declared per share | $0.25 | $0.25 | $0.75 | $0.75 |
Q3 net income attributable to common stockholders increased approximately 128% year over year, while nine-month net income increased approximately 64%. The filing does not provide a single consolidated operating or net profit margin; based on reported figures, net income attributable to common stockholders represented approximately 39% of Q3 revenue and 39% of nine-month revenue.
At September 30, 2015, total assets were $1.50 billion, including $1.27 billion of loans held for investment, $94.1 million of loans held for sale and $60.1 million of mortgage servicing rights. Total equity was $491.6 million, including $407.6 million attributable to common stockholders and $84.1 million of non-controlling interests.
The principal lending portfolio, excluding third-party non-controlling interests, had $1.19 billion of outstanding principal, a 5.5% weighted-average interest rate, a 6.0% weighted-average unleveraged effective yield and a 2.3-year weighted-average remaining life. Senior mortgage loans represented $989.8 million of principal, while subordinated debt and preferred equity represented $204.1 million.
Cash flow, debt and liquidity
- Cash and cash equivalents were $10.4 million at September 30, 2015, compared with $16.6 million at December 31, 2014. Restricted cash was $27.2 million.
- Nine-month operating cash flow was $204.6 million, compared with negative $13.1 million in the prior-year period.
- Nine-month investing cash flow was $197.3 million, compared with negative $193.6 million in 2014, primarily reflecting loan repayments exceeding new loan fundings.
- Nine-month financing cash flow was negative $408.0 million, primarily due to repayments of secured funding, securitization debt and warehouse borrowings.
- Secured funding agreements totaled $521.7 million outstanding against $1.03 billion of commitments. Warehouse lines totaled $83.5 million outstanding against $215.0 million of commitments.
- Additional debt included $68.9 million of convertible notes, $61.9 million of CMBS debt and $222.2 million of CLO debt.
- As of November 3, 2015, management reported approximately $70 million of capital in cash or approved but undrawn secured funding capacity. Borrowings under financing facilities were approximately $481 million, excluding mortgage-banking warehouse lines.
- Management stated that current liquidity and access to additional liquidity were expected to be sufficient to repay the $69.0 million aggregate principal amount of 7.00% convertible senior notes maturing December 15, 2015.
Material changes versus the prior comparable period
- Net interest margin increased from $8.4 million to $12.2 million in Q3 and from $26.2 million to $37.5 million for the first nine months. Management attributed the increase to third-party non-controlling-interest income, higher earning assets, lower borrowing costs and greater leverage.
- Mortgage banking revenue increased from $4.8 million to $11.7 million in Q3 and from $17.5 million to $26.9 million year to date. Gains from mortgage banking activities increased to $9.2 million in Q3 and $20.8 million for the first nine months, supported by higher loan originations.
- ACRE Capital rate-locked 20 loans totaling $207.5 million in Q3, compared with 11 loans totaling $52.0 million in Q3 2014. For the first nine months, it rate-locked 67 loans totaling $642.5 million, compared with 21 loans totaling $183.3 million.
- Servicing fees declined to $11.9 million for the first nine months from $12.6 million, while the fair value reduction in mortgage servicing rights increased to $7.0 million from $5.5 million.
- Total expenses were broadly stable at $11.0 million in Q3 and $30.9 million for the first nine months. Higher compensation and performance-based commissions were substantially offset by lower general and administrative expenses following completion of the ACRE Capital restructuring.
- Loans held for investment declined from $1.46 billion at year-end 2014 to $1.27 billion at September 30, 2015, reflecting $275.2 million of repayments and the sale of a $75.0 million loan, partly offset by approximately $154.5 million of new funding and additional funding.
- Secured funding agreements and warehouse lines declined from $746.0 million and $193.2 million outstanding, respectively, at December 31, 2014, to $605.2 million and $83.5 million at September 30, 2015.
Guidance, outlook, management commentary and risks
- Management expects to continue using leverage, currently targeting no more than a 4-to-1 debt-to-equity ratio, subject to market conditions and financing availability.
- ACRE intends to make regular quarterly distributions and declared a $0.25 per-share fourth-quarter 2015 dividend payable January 19, 2016.
- As of September 30, all loans were paying according to contractual terms, and no impairments were recorded for loans held for investment during Q3 or the first nine months.
- Unfunded commitments for existing investment loans were $116.6 million at September 30, 2015; commitments to fund ACRE Capital loans were $118.5 million and commitments to sell loans were $207.1 million.
- ACRE Capital remains subject to Fannie Mae DUS loss-sharing obligations. The maximum quantifiable allowance associated with guarantees was $1.1 billion, but management stated this amount does not represent the expected actual loss exposure. The recorded allowance for loss sharing was $9.0 million.
- Interest-rate risk remains significant. The company primarily uses floating-rate assets and index-matched floating-rate liabilities, but higher rates could increase borrowing costs, pressure borrowers and reduce asset values. A 100-basis-point increase in the MSR discount rate would reduce MSR fair value by approximately $1.9 million as of September 30, 2015.
- Other key risks include commercial real estate credit deterioration, declining property values, refinancing and extension risk, prepayments, financing-counterparty liquidity, securitization cash-flow priority, dependence on Ares Management and the ability to maintain REIT and Investment Company Act exemptions.
- Todd Schuster resigned as CEO, President and director during Q3. John Jardine became a director, President and Co-Chief Executive Officer, and Robert L. Rosen became Interim Co-Chief Executive Officer.
- The July 2014 CNB Facility was extended to July 31, 2016, and the December 2014 UBS Facility was extended to July 6, 2016. Subsequent to quarter-end, the April 2014 UBS Facility was extended to October 21, 2018, subject to annual extensions at UBS’s discretion.
- No material pending legal proceedings, defaults under senior securities or material changes to previously disclosed risk factors were reported.
Most important facts for investors to verify
- Ability to refinance or repay the $69.0 million convertible notes due December 15, 2015 and the timing of related funding actions.
- Actual availability and borrowing-base capacity under secured funding and warehouse facilities, including facility maturity extensions and covenant compliance.
- Credit performance, collateral values and refinancing prospects for the $1.19 billion principal lending portfolio, particularly loans maturing in 2015–2017.
- Sustainability of elevated mortgage banking gains and whether Q3 origination volume and rate-lock activity persist.
- Valuation sensitivity of the $60.1 million MSR portfolio and exposure to prepayments, discount rates and servicing costs.
- Potential Fannie Mae DUS loss-sharing claims relative to the $9.0 million recorded allowance and the $1.1 billion maximum quantifiable exposure.
- Impact of management turnover, related-party management fees and the 1.5% base management fee structure.
- Coverage of the $0.25 quarterly dividend by recurring taxable income and cash available after debt service and unfunded commitments.