Ares Commercial Real Estate Corp annual report, FY2016

Ares Commercial Real Estate Corporation — 2016 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2016; filed March 7, 2017. The filing is an annual report, not a standalone fourth-quarter filing. ACRE is an externally managed REIT focused primarily on originating and investing in commercial real estate debt, including senior mortgage loans, subordinated debt, preferred equity and mezzanine loans.

Business Context and Reporting Changes

ACRE operates as a specialty finance company and is managed by Ares Commercial Real Estate Management LLC, an affiliate of Ares Management, L.P.
On September 30, 2016, ACRE sold its mortgage banking subsidiary, ACRE Capital Holdings LLC, to Barings Real Estate Advisers for approximately $93 million in cash and recognized a net gain of approximately $10.2 million.
The mortgage banking business is presented as discontinued operations for all periods. ACRE now reports one operating segment focused on its core commercial real estate lending business.
ACRE remains qualified as a REIT and operates to maintain its exemption from registration under the Investment Company Act of 1940.

Financial Performance and Key Metrics

Metric	2016	2015	Change
Interest income	$82.0 million	$86.3 million	Down $4.4 million
Net interest margin	$45.1 million	$50.0 million	Down $4.9 million
Total expenses	$14.4 million	$13.7 million	Up $0.8 million
Net income from continuing operations	$30.5 million	$36.3 million	Down $5.9 million
Discontinued-operations income	$4.2 million	$7.0 million	Down $2.8 million
Gain on sale of discontinued operations	$10.2 million	—	Unusual item
Net income attributable to common stockholders	$40.3 million	$34.3 million	Up $6.1 million
Diluted earnings per share	$1.41	$1.20	Up $0.21
Dividends declared per share	$1.04	$1.00	Up $0.04

Continuing-operations revenue was $45.1 million, consisting primarily of interest income. Net income from continuing operations represented approximately 67.5% of continuing-operations revenue.
The decline in net interest margin primarily reflected a $4.5 million reduction in interest income attributable to non-controlling interests following loan prepayments.
Management and incentive fees to the external manager were $6.0 million, including $348 thousand of incentive fees; no incentive fees were incurred in 2015 or 2014.
No impairments were recorded on loans held for investment in 2016, 2015 or 2014, and all loans were paying according to contractual terms at December 31, 2016.

Portfolio, Balance Sheet, Cash Flow and Liquidity

Loans held for investment totaled $1.314 billion at year-end, compared with $1.174 billion in 2015. The portfolio included 31 loans, with outstanding principal of approximately $1.312 billion.
Senior mortgage loans represented approximately $1.188 billion of outstanding principal, with a weighted-average interest rate of 4.7% and weighted-average unleveraged effective yield of 5.7%.
Subordinated debt and preferred equity totaled approximately $123.2 million of outstanding principal, with a weighted-average interest rate of 10.7% and weighted-average unleveraged effective yield of 11.5%.
Approximately 82.5% of loans had LIBOR floors, with a weighted-average floor of 0.38% for loans subject to floors.
Total assets were $1.374 billion; total liabilities were $944.0 million; total equity was $429.7 million; and stockholders’ equity was $419.0 million.
Outstanding Financing Agreements totaled $935.7 million, comprising $780.7 million of secured funding agreements and $155.0 million of secured term debt. The secured term loan bears interest at LIBOR plus 6.0%, subject to a 1.0% LIBOR floor, and matures in December 2018.
Cash and cash equivalents were $47.3 million at year-end, compared with $5.1 million of continuing-operations cash at year-end 2015. Restricted cash was $375 thousand.
Net cash provided by operating activities was $8.5 million; net cash used in investing activities was $43.3 million; and net cash provided by financing activities was $73.1 million. Cash increased by $38.3 million during the year.
Unfunded commitments on existing loans totaled $69.2 million at December 31, 2016, including approximately $11.7 million due within one year and $55.0 million due in one to three years.
Approximately $271.2 million of financing-agreement principal was scheduled to mature in 2017, before considering available extensions or refinancing.

Material Changes Versus the Prior Comparable Period

The loan portfolio increased by approximately $139.5 million, or 11.9%, from year-end 2015, reflecting substantial new originations partly offset by repayments.
During 2016, ACRE funded approximately $863.5 million of outstanding principal and received approximately $685.6 million of principal repayments.
Net interest margin declined approximately 9.8%, while continuing-operations net income declined approximately 16.2%.
Net income attributable to common stockholders increased approximately 17.7%, but the increase was driven primarily by the $10.2 million gain on the ACRE Capital sale.
Secured borrowings increased from $597.8 million at year-end 2015 to $935.7 million at year-end 2016. ACRE expanded the Wells Fargo and BAML facilities, amended the Citibank facility, added a U.S. Bank facility and drew the remaining $80.0 million under the secured term loan.
The CMBS securitization and CLO securitization were terminated and repaid in full during 2016. The related securitization debt declined from $254.3 million at year-end 2015 to zero.
ACRE repurchased 129,916 shares for approximately $1.4 million, or $11.06 per share on average, under its $30 million stock repurchase authorization.
Quarterly dividends increased from $0.25 per share in 2015 to $0.26 per share in each quarter of 2016.

Guidance, Outlook, Risks and Unusual Items

Management characterized market conditions as favorable for disciplined, scaled direct lenders offering customized, shorter-duration and often floating-rate CRE loans. The filing does not provide formal earnings or portfolio guidance.
Management expects leverage generally not to exceed a 4-to-1 debt-to-equity ratio, although the charter does not impose a leverage limit and actual leverage may vary.
As of December 31, 2016, ACRE reported compliance with the financial covenants under its Financing Agreements.
Key risks include borrower defaults, declining commercial real estate values, refinancing and extension risk, interest-rate volatility, prepayments, illiquidity, concentration in a limited number of loans, financing availability, margin calls and covenant breaches.
The portfolio is concentrated: 31 loans were held for investment, and 25.3% of loan outstanding principal involved borrowers sharing a common sponsor.
Rising rates could increase borrowing costs and pressure net interest margins, although the company primarily uses floating-rate assets and index-matched floating-rate liabilities. Management estimated that a 100-basis-point increase in average 30-day LIBOR would increase annual net interest margin by approximately $2.6 million, subject to portfolio composition and rate floors.
The external management agreement expires May 1, 2017 and automatically renews for one-year terms unless terminated under its provisions. Termination may require a fee equal to three times specified average management and incentive fees.
ACRE must generally distribute at least 90% of REIT taxable income. It accrued $209 thousand of excise tax in 2016 and has no guaranteed minimum dividend.
Subsequent to year-end, ACRE originated four senior mortgage loans with aggregate initial commitments of approximately $133.7 million. On March 2, 2017, it issued approximately $272.9 million of secured floating-rate notes backed by a pool of 12 mortgage assets and retained approximately $68.2 million of non-investment-grade notes and preferred equity.
On March 7, 2017, ACRE declared a first-quarter 2017 dividend of $0.27 per share.

Most Important Facts for Investors to Verify

Whether the reported increase in earnings is appropriately adjusted for the one-time $10.2 million gain from the ACRE Capital sale.
The sustainability of the $0.26 quarterly dividend and the effect of REIT distribution requirements, debt covenants and liquidity needs.
The maturity and refinancing risk associated with approximately $271.2 million of scheduled 2017 financing-agreement maturities.
Portfolio credit quality, collateral values, sponsor concentrations, loan extensions and the absence of impairment charges despite the portfolio’s concentration and leverage.
The impact of higher LIBOR on both loan yields and borrowing costs, including the company’s rate floors, caps and hedging strategy.
The terms, advance rates, covenants and retained risk of the March 2017 securitization.
Management fees, incentive-fee mechanics, expense reimbursements and potential conflicts arising from the external-management structure.