Ares Commercial Real Estate Corporation: FY2018 Form 10-K Summary
Business context and reporting period
Ares Commercial Real Estate Corporation is an externally managed specialty finance company that originates and invests primarily in commercial real estate loans and related investments. The company targets senior mortgage loans, subordinated debt, preferred equity, mezzanine loans and other CRE investments. It has elected REIT status and seeks to maintain an exemption from registration under the Investment Company Act of 1940.
This Form 10-K covers the fiscal year ended December 31, 2018. The filing includes unaudited quarterly information for the fourth quarter, but it is an annual report rather than a standalone Form 10-Q.
Financial performance and key metrics
| Metric | FY2018 | FY2017 | Change |
|---|---|---|---|
| Interest income from loans | $118.3 million | $97.5 million | +21.2% |
| Interest expense | $63.0 million | $51.2 million | +23.1% |
| Net interest margin | $55.3 million | $46.3 million | +19.3% |
| Total expenses | $16.2 million | $15.0 million | +8.5% |
| Net income attributable to common stockholders | $38.6 million | $30.4 million | +26.9% |
| Diluted earnings per share | $1.35 | $1.07 | +26.2% |
| Dividends declared per share | $1.16 | $1.08 | +7.4% |
| Loans held for investment | $1.525 billion | $1.726 billion | -11.7% |
| Total assets | $1.603 billion | $1.770 billion | -9.4% |
| Stockholders’ equity | $425.6 million | $419.2 million | +1.5% |
Fourth-quarter 2018 net interest margin was $14.5 million, net income attributable to common stockholders was $10.0 million, and basic and diluted earnings per share were $0.35.
Operating cash flow was $39.2 million, compared with $31.3 million in 2017. Investing activities generated $157.9 million, primarily because loan repayments exceeded new loan fundings. Financing activities used $214.4 million, including $822.2 million of secured-funding repayments, $642.2 million of new secured-funding proceeds and $32.1 million of dividends paid. Cash, cash equivalents and restricted cash ended the year at $11.5 million, including $11.1 million of cash and cash equivalents.
Total debt consisted of $888.0 million under financing agreements and $270.7 million of CLO securitization debt, for approximately $1.159 billion in aggregate reported debt. The company was in compliance with its financing covenants at December 31, 2018. Its stated leverage objective was not to exceed 4.0-to-1.0 debt to equity, subject to market conditions and other factors.
Portfolio and credit profile
- The portfolio comprised 44 loans with $1.535 billion of outstanding principal and a $1.525 billion carrying amount.
- Senior mortgage loans represented $1.499 billion of outstanding principal, with a 7.0% weighted-average unleveraged effective yield and 1.7-year weighted-average remaining life.
- Subordinated debt and preferred equity represented $36.2 million of outstanding principal, with a 14.9% weighted-average unleveraged effective yield.
- Approximately 89.8% of loans had LIBOR floors, with a weighted-average floor of 1.38% for loans with floors.
- The company funded approximately $544.2 million of outstanding principal and received approximately $746.8 million of principal repayments during 2018.
- No loan impairment charges were recognized in 2018, 2017 or 2016. Except for the disclosed New York hotel loan, loans were reported as paying according to contractual terms.
Material changes versus the prior comparable period
- Net interest margin increased by $8.9 million, driven by higher weighted-average earning assets, higher borrowings and increased 30-day LIBOR.
- Net income increased by $8.2 million, while expenses rose by $1.3 million. Management and incentive fees increased to $7.4 million from $6.6 million, including incentive fees of $1.2 million versus $0.4 million.
- The loan portfolio declined by approximately $201.4 million as repayments exceeded new fundings, although the reported weighted-average effective yield increased from 6.3% to 7.1%.
- Secured funding agreements declined to $778.0 million from $958.0 million. The company repaid the UBS facility at maturity in October 2018.
- The Wells Fargo facility was extended to December 2020 and its pricing margin was reduced. The Citibank facility was increased from $250 million to $325 million, extended to December 2021, and repriced at lower indicative margins.
- Annual dividends declared increased to $1.16 per share from $1.08 per share.
- There were no public equity offerings or share repurchases in 2018.
Guidance, outlook, commentary and unusual items
Management described market conditions as favorable for scaled direct lenders, citing demand for customized, shorter-duration and often floating-rate CRE financing. It expected continued opportunities in value-added and transitional real estate lending, while noting that rising interest rates, withdrawal of central-bank support and market volatility could pressure asset values and financing conditions.
As of December 31, 2018, a $38.6 million senior mortgage loan secured by a New York hotel was in maturity default because the borrower did not repay at the December 2018 maturity date. The loan remained current on regular interest payments, was not placed on non-accrual status and had no impairment charge based on collateral value and operating cash flows.
Contractual commitments included $142.9 million of unfunded loan commitments, of which $13.1 million was expected within one year and $122.1 million within one to three years. Financing principal maturities totaled $36.3 million in 2019, $667.7 million in 2020 and $184.0 million in 2021, excluding variable interest and extension options.
On January 11, 2019, the company completed an amended CLO securitization with approximately $504.1 million of secured floating-rate notes and $52.9 million of preferred equity. It retained approximately $58.5 million of non-investment-grade notes and all preferred equity. In February 2019, it originated two additional senior mortgage loans and declared a first-quarter 2019 dividend of $0.33 per share.
Key risks include borrower defaults and collateral deterioration, portfolio concentration, refinancing and liquidity risk, margin calls, rising financing costs, LIBOR discontinuation, securitization subordination, illiquid investments, competition, conflicts with the external manager, REIT qualification, maintenance of the 1940 Act exemption and the ability to sustain distributions.
Most important facts for investors to verify
- Monitor the New York hotel maturity default, collateral valuation, repayment prospects and any later impairment or non-accrual treatment.
- Review the timing and refinancing terms for the 2019–2021 financing maturities and the company’s limited $11.5 million cash and restricted-cash balance.
- Assess the impact of loan repayments on portfolio size, future interest income and reinvestment yields.
- Examine the $142.9 million of unfunded loan commitments and the company’s ability to fund them while maintaining liquidity and covenant compliance.
- Evaluate exposure to LIBOR transition, floating-rate asset and liability repricing, loan floors and interest-rate hedging.
- Review the CLO’s retained subordinated interests and preferred equity, including the stated $68.2 million maximum risk of loss at December 31, 2018 and the subsequent 2019 refinancing.
- Consider external-manager fees, incentive compensation, allocation conflicts and the management agreement’s May 1, 2019 renewal and termination provisions.
- Confirm dividend sustainability against operating cash flow, REIT distribution requirements, debt covenants and taxable income.
- Reconcile portfolio funding and repayment figures, because the filing presents approximately $544.2 million of fundings and $746.8 million of repayments in portfolio disclosures, while the cash-flow statement reports $543.1 million of loan fundings and $695.2 million of principal repayments.