Ares Commercial Real Estate Corporation — 2014 Q3 Form 10-Q Summary
Business context and reporting period
Ares Commercial Real Estate Corporation is an externally managed specialty finance company operating through two segments: principal lending, focused on commercial real estate debt investments, and mortgage banking, conducted through ACRE Capital and focused primarily on multifamily and senior-living loans originated, sold and serviced under Fannie Mae, Freddie Mac and HUD programs. The filing covers the unaudited three and nine months ended September 30, 2014, with comparisons to September 30, 2013 and December 31, 2013 balance-sheet amounts.
Key financial metrics
| Metric | Three months ended September 30, 2014 | Three months ended September 30, 2013 | Nine months ended September 30, 2014 | Nine months ended September 30, 2013 |
|---|---|---|---|---|
| Total revenue | $15.0 million | $12.6 million | $49.6 million | $24.1 million |
| Net interest margin | $10.0 million | $8.7 million | $30.9 million | $20.2 million |
| Income from operations before acquisition gain and taxes | $2.9 million | $2.9 million | $13.7 million | $6.5 million |
| Net income | $4.1 million | $6.9 million | $15.5 million | $10.5 million |
| Basic and diluted earnings per share | $0.14 | $0.25 | $0.54 | $0.66 |
| Dividends declared per share | $0.25 | $0.25 | $0.75 | $0.75 |
- September 30, 2014 total assets were $1.40 billion, up from $1.18 billion at December 31, 2013. Stockholders’ equity was $401.0 million versus $406.2 million.
- Loans held for investment were $1.238 billion, compared with $958.5 million at year-end 2013. Outstanding principal was $1.247 billion across 43 loans, with a weighted-average interest rate of 5.1% and unleveraged effective yield of 5.6%.
- The portfolio consisted primarily of senior mortgage loans, with $1.102 billion of carrying value, and subordinated debt and preferred equity investments, with $135.8 million.
- Mortgage servicing rights were $59.6 million, supporting a servicing portfolio of 995 loans with approximately $4.0 billion of unpaid principal balance.
- Cash and cash equivalents were $11.4 million, supplemented by $24.1 million of restricted cash.
- Net cash used in operating activities was $13.1 million; net cash used in investing activities was $193.6 million; net cash provided by financing activities was $198.0 million. Cash decreased by $8.7 million during the nine months.
- Debt and funding liabilities included $342.0 million of secured funding agreements, $17.5 million of warehouse lines, $68.2 million of convertible notes, $219.0 million of CMBS debt and $308.7 million of CLO debt.
- Total secured funding commitments were $1.075 billion, of which $342.0 million was outstanding; warehouse commitments were $80.0 million, of which $17.5 million was outstanding.
- The 7.00% convertible notes had a carrying value of $68.2 million and mature December 15, 2015.
Material changes versus prior comparable periods
- Net interest margin increased as the principal lending portfolio expanded from 24 loans at September 30, 2013 to 43 loans at September 30, 2014. However, interest expense increased materially because of higher leverage and funding costs.
- Nine-month mortgage banking revenue increased to $18.0 million from $3.9 million, primarily because the 2013 comparison included only one month of ACRE Capital operations following its August 2013 acquisition.
- Third-quarter net income declined despite higher revenue because the prior-year quarter included a $4.4 million gain on acquisition. No comparable acquisition gain was recorded in 2014.
- Third-quarter earnings per share declined to $0.14 from $0.25, reflecting the absence of the acquisition gain, higher expenses and a larger share base. Nine-month earnings per share declined to $0.54 from $0.66 for the same principal reasons.
- Compensation and benefits increased to $13.2 million for the nine months from $1.8 million, and general and administrative expense increased to $7.3 million from $1.9 million, largely because ACRE Capital was consolidated for the full 2014 period but only partially for the 2013 comparison.
- On August 15, 2014, the Company completed a CLO transaction with approximately $346.1 million of notes and $32.7 million of preferred equity. Third-party offered notes outstanding were approximately $308.7 million at quarter-end.
- The Company entered into new or expanded financing arrangements, including a $75.0 million City National Bank facility and a $180.0 million MetLife repurchase facility. Ares Management provided credit support for the July 2014 CNB facility, and the Company pledged its ownership interests in ACRC Holdings LLC to Ares.
- ACRE Capital acquired servicing rights on 46 Freddie Mac multifamily loans with approximately $370.6 million of unpaid principal balance and received a Freddie Mac Program Plus license. The total purchase price was approximately $2.2 million.
- Restructuring and relocation costs were $778 thousand for the nine months, with an additional $111 thousand expected. The filing states that restructuring costs were expected to continue through the first quarter of 2015.
Guidance, outlook, commentary and risks
- Management described demand for customized transitional and flexible commercial real estate financing as favorable, while noting increased competition, refinancing activity and higher prepayment rates.
- As of November 7, 2014, management expected approximately $80 million of cash or approved undrawn capacity. After reserving $10 million for liquidity requirements, approximately $70 million was expected to be available for new loans, existing commitments and working capital. At 2:1 to 3:1 debt-to-equity leverage, management estimated capacity for approximately $210 million to $280 million of additional senior loan investments.
- The Company declared a fourth-quarter 2014 dividend of $0.25 per share, payable January 15, 2015.
- Management expects to use leverage, securitizations, repurchase facilities, warehouse lines and equity or debt offerings to fund investments. Its stated leverage expectation was not to exceed 4:1 debt-to-equity, subject to market and financing conditions.
- All loans were reported as paying according to contractual terms, and no impairment charges were recognized during the periods presented. Nevertheless, the portfolio remains exposed to commercial real estate values, borrower defaults, refinancing and recovery risk.
- Interest-rate risk remains significant. Most assets and liabilities are floating-rate and index-matched, but a 100-basis-point increase in average 30-day LIBOR was estimated to increase loan portfolio net interest margin by approximately $276 thousand for the quarter and $858 thousand for the nine months, based on the quarter-end portfolio.
- The Fannie Mae DUS risk-sharing arrangement creates contingent exposure. The maximum quantifiable loss-sharing allowance was approximately $1.2 billion at September 30, 2014, although the filing states this is not representative of expected actual losses. The recorded allowance for loss sharing was $13.3 million.
- Unfunded principal-lending commitments were $168.6 million. ACRE Capital also had $39.8 million of commitments to sell loans and $15.7 million of commitments to fund loans.
- Principal repayments in the consolidated CMBS and CLO structures are applied first to senior securities, potentially delaying cash distributions to the Company’s retained subordinated interests.
- Risks include funding availability, margin calls, covenant compliance, interest-rate movements, credit losses, prepayments, MSR valuation changes, competition, GSE program changes, REIT qualification and the ability to maintain exemption from Investment Company Act registration. The Company reported compliance in all material respects with its financing covenants and no material pending legal proceedings.
Most important facts for investors to verify
- Reconcile reported net income and earnings per share to recurring earnings, excluding the 2013 acquisition gain and other unusual items.
- Assess the sustainability of the $0.25 quarterly dividend against recurring earnings, operating cash flow and required debt repayments.
- Review debt maturities, extension conditions, collateral requirements and covenant headroom, particularly the Wells Fargo facility’s December 2014 initial maturity and the convertible notes’ December 2015 maturity.
- Evaluate the quality, concentration, leverage and maturity profile of the $1.247 billion loan portfolio, including subordinated and preferred equity exposures.
- Quantify potential exposure under the Fannie Mae DUS loss-sharing arrangements and compare it with the $13.3 million recorded allowance.
- Monitor liquidity after the $168.6 million of unfunded loan commitments and determine whether management’s projected $210 million to $280 million investment capacity is achievable.
- Test the sensitivity of MSRs and earnings to prepayments, discount rates, GSE production and servicing economics; a 100-basis-point discount-rate change would affect MSR fair value by approximately $1.8 million.
- Confirm the terms and economic impact of the CLO, the Ares credit support arrangement and the pledge of ACRC Holdings LLC.