Ares Commercial Real Estate Corp annual report, FY2022

Ares Commercial Real Estate Corporation — 2022 Form 10-K Summary

Business context and reporting period

ACRE is an externally managed specialty finance company and REIT focused primarily on originating and investing in commercial real estate loans and related investments. The filing covers the fiscal year ended December 31, 2022, with audited financial statements for 2022, 2021 and 2020. ACRE had 60 loans held for investment at year-end, with $2.3 billion of outstanding principal and a $2.3 billion carrying amount before the CECL reserve.

The company is managed by Ares Commercial Real Estate Management LLC, has no employees, and operates to maintain its REIT status and exemption from registration under the Investment Company Act of 1940.

Key financial metrics

Metric	2022	2021	Change
Total revenue	$106.8 million	$102.1 million	+$4.8 million
Net interest margin	$104.2 million	$83.6 million	+$20.6 million
Total expenses	$32.7 million	$40.9 million	-$8.1 million
CECL provision	$46.1 million	$0.01 million	+$46.1 million
Gain on sale of real estate owned	$2.2 million	—	+$2.2 million
Net income attributable to common stockholders	$29.8 million	$60.5 million	-$30.7 million
Diluted earnings per share	$0.57	$1.42	-$0.85
Net cash from operating activities	$57.2 million	$48.4 million	+$8.8 million

Net income declined materially despite higher interest income and net interest margin, primarily because the CECL provision increased to $46.1 million from nominal levels in 2021. The filing does not provide a consolidated GAAP net margin percentage; based on reported figures, net income represented approximately 27.9% of revenue in 2022 versus approximately 59.2% in 2021.

Portfolio, liquidity and capital structure

Loans held for investment totaled $2.264 billion before CECL and $2.198 billion net of the $66.0 million reserve for funded balances.
Total CECL reserves were $71.3 million, including $66.0 million for funded loans and $5.3 million for unfunded commitments, versus $25.2 million at December 31, 2021.
The portfolio had a weighted average unleveraged effective yield of 8.5% and a weighted average remaining life of 1.4 years. Senior mortgage loans comprised most of the portfolio.
Approximately 99% of investments were floating-rate loans, and 90.2% of loans had LIBOR or SOFR floors averaging 0.95% among loans with floors.
Total financing-agreement borrowings were $960.2 million, and CLO securitization debt was $777.7 million carrying value, or $779.0 million outstanding principal.
Total liabilities were $1.775 billion and stockholders’ equity was $747.5 million at year-end. The company reported compliance with all financing covenants.
Cash and cash equivalents were $141.3 million at December 31, 2022. As of February 14, 2023, management reported approximately $216 million of liquidity, consisting of $141 million of unrestricted cash and $75 million of available borrowing capacity.
Future loan funding commitments totaled $227.5 million, including $36.3 million due within one year.
ACRE declared $1.40 per share of 2022 cash dividends, consisting of quarterly $0.33 regular dividends and $0.02 supplemental dividends.

Material changes versus the prior comparable period

Interest income increased to $170.2 million from $133.6 million, reflecting larger weighted-average earning assets, higher LIBOR and SOFR rates, hedging benefits and accelerated recognition of fees and prepayment penalties.
Interest expense increased to $66.0 million from $50.1 million as borrowings and benchmark rates increased.
The CECL reserve rose sharply, reflecting new loan production and management’s assessment of inflation, rapidly rising interest rates and recessionary conditions.
The loan portfolio declined to 60 loans from 72, and carrying value declined to $2.264 billion from $2.414 billion, primarily reflecting repayments exceeding new funding.
ACRE funded approximately $676.9 million of outstanding principal and received approximately $823.2 million of repayments during 2022.
The company sold its hotel real estate owned for $40.0 million on March 1, 2022 and recognized a $2.2 million gain. Hotel revenue declined to $2.7 million from $18.5 million because 2022 included only two months of hotel operations.
ACRE issued 7.0 million common shares in May 2022 for net proceeds of approximately $103.2 million and sold 190,369 shares under its at-the-market program for approximately $2.9 million. The at-the-market program was subsequently unavailable.
ACRE amended or extended several financing arrangements, including the Wells Fargo, Citibank, CNB, MetLife and Morgan Stanley facilities. The Wells Fargo facility’s initial maturity was extended to December 2025, subject to extensions.
Management terminated an interest-rate cap with a $170.0 million notional amount in March 2022 and recognized a $2.0 million realized gain in other comprehensive income, with related amounts recognized in earnings over the original hedge term.

Guidance, outlook, management commentary, risks and unusual items

Management expects existing sources of cash to be sufficient for operating activities and cash commitments for at least the next 12 months, but this expectation is subject to borrower performance, financing availability, margin requirements, covenant compliance and market conditions. ACRE currently expects leverage not to exceed 4.5-to-1 debt-to-equity under current conditions, although its charter does not impose a leverage limit.

Management highlighted potential opportunities for floating-rate CRE lending because banks and other lenders may be constrained by capital and regulatory requirements. At the same time, the company expects continued uncertainty from inflation, monetary tightening, higher interest rates, recession risk, geopolitical conditions and reduced CRE transaction volumes.

Three loans were on non-accrual status at December 31, 2022, with a carrying value of $99.1 million, compared with two loans totaling $45.0 million at year-end 2021. No loan write-offs occurred in 2022.
Subsequent to year-end, an Illinois office loan with a $27.2 million balance reached maturity default, a California mixed-use loan with a $37.9 million balance missed its January interest payment and entered default, and a Florida mixed-use loan with an $84.0 million balance reached maturity default in February 2023.
ACRE sold a maturity-defaulted California residential loan for $10.0 million in January 2023, with estimated net proceeds of $9.8 million.
LIBOR transition remains material: as of December 31, 2022, approximately $1.2 billion of floating-rate investments and $1.1 billion of floating-rate debt had extended maturities tied exclusively to LIBOR. The company expects conversion to SOFR or another replacement rate to create potential basis mismatches, higher borrowing costs or lower investment returns.
Credit and liquidity risks include borrower defaults, declining collateral values, loan extensions, margin calls, refinancing risk, CLO overcollateralization tests and the potential acceleration of secured debt.
ACRE is exposed to office, hotel, multifamily and other CRE risks, including reduced office demand, tenant stress, refinancing difficulty and declining property values.
The company pays its external manager a base management fee equal to 1.5% of stockholders’ equity, incentive fees and expense reimbursements. Management and incentive fees totaled $14.9 million in 2022, including $3.4 million of incentive fees.
The company’s auditor issued unqualified opinions on the financial statements and internal control over financial reporting. The critical audit matter was the highly judgmental CECL reserve.

Most important facts for investors to verify

Whether the $71.3 million CECL reserve adequately reflects deterioration in CRE collateral, borrower cash flows, office exposure and recession assumptions.
The status, collateral value and resolution strategy for the three year-end non-accrual loans and the subsequent Illinois, California and Florida defaults.
Actual liquidity after any margin calls, collateral requirements, loan funding commitments and debt repayments.
The maturity and refinancing plan for $198.2 million of Morgan Stanley borrowings due in 2024 and $612.0 million of financing-agreement borrowings due in 2025.
The economic impact of converting approximately $1.2 billion of LIBOR-linked investments and $1.1 billion of LIBOR-linked debt to SOFR or other replacement rates.
Compliance with CLO overcollateralization tests and the effect of any cash-flow diversion from subordinated interests to senior note repayment.
Whether cash flow from operations continues to support the $0.35 per share quarterly dividend, given REIT distribution requirements, debt covenants and rising credit costs.
The potential effect of external management fees, incentive compensation, related-party transactions and Ares allocation practices on stockholder returns.