Business Context and Reporting Period
Ares Commercial Real Estate Corporation is an externally managed specialty finance company focused on originating and managing commercial real estate debt investments. It also operated a mortgage banking business through ACRE Capital, which originated, sold and serviced multifamily and senior-living loans for GSE and HUD programs.
This unaudited Form 10-Q covers the three and six months ended June 30, 2016, with comparative periods ended June 30, 2015. The mortgage banking business was classified as discontinued operations following the June 28, 2016 agreement to sell ACRE Capital Holdings LLC to Cornerstone Real Estate Advisers LLC.
Financial Position and Key Metrics
| Metric | Q2 2016 | Six Months 2016 | Comparable Period |
|---|---|---|---|
| Interest income from loans held for investment | $18.9 million | $37.7 million | $21.0 million and $44.2 million |
| Net interest margin | $10.5 million | $20.7 million | $12.3 million and $25.3 million |
| Net income from continuing operations | $7.3 million | $14.1 million | $9.1 million and $18.5 million |
| Net income attributable to common stockholders | $8.7 million | $13.8 million | $9.0 million and $16.0 million |
| Diluted earnings per share | $0.31 | $0.48 | $0.31 and $0.56 |
| Dividends declared per share | $0.26 | $0.52 | $0.25 and $0.50 |
- Net interest margin as a percentage of interest income was approximately 55.6% in Q2 and 55.1% for the first six months, compared with approximately 58.6% and 57.3%, respectively, in the prior-year periods.
- Total assets were $1.332 billion at June 30, 2016, versus $1.379 billion at December 31, 2015. Total equity was $454.3 million, including $47.0 million of non-controlling interests.
- Loans held for investment totaled $1.143 billion, including $1.096 billion attributable to the Company’s portfolio excluding third-party non-controlling interests. The portfolio comprised 33 loans, with a weighted-average interest rate of 5.3% and unleveraged effective yield of 6.1%.
- Senior mortgage loans represented $928.0 million of carrying value; subordinated debt and preferred equity investments represented $168.4 million.
- All loans were reported as paying according to contractual terms, and no impairment charges were recorded during the quarter or first six months.
- Cash and cash equivalents were $5.3 million in continuing operations, with restricted cash of $11.7 million. Cash and cash equivalents across continuing and discontinued operations totaled $6.3 million at June 30, 2016.
- Outstanding secured funding agreements were $601.8 million, the secured term loan was $70.2 million, and consolidated CLO debt was $104.7 million. The Company also had $46.4 million of warehouse-line debt classified within discontinued operations.
- Financing commitments totaled $1.440 billion, with $723.2 million outstanding. Unfunded commitments on principal lending investments were $86.5 million.
- Net cash provided by operating activities was $33.4 million, investing activities provided $33.6 million, and financing activities used $69.7 million. Cash decreased by $2.7 million during the first six months.
Material Changes, Outlook and Risks
- Interest income and net interest margin declined primarily because average earning assets decreased to approximately $1.2 billion from $1.3 billion in the prior-year periods. Average borrowings also declined.
- The Company agreed to sell ACRE Capital Holdings for $93 million in cash, subject to working-capital and other adjustments, including a potential adjustment of up to $3 million. Closing was expected in the third or fourth quarter of 2016 and depended on customary conditions, including GSE and governmental approvals.
- The mortgage banking business generated $2.7 million of Q2 net income and $2.4 million for the first six months, but included $515,000 of transaction costs during the first six months. Its assets and liabilities held for sale were $159.6 million and $77.5 million, respectively.
- The CMBS securitization was terminated on June 17, 2016, and all third-party certificates were repaid. CMBS debt declined from $61.8 million at year-end to zero; CLO debt declined from $192.5 million to $104.7 million.
- The Wells Fargo facility was increased from $225 million to $325 million and extended to December 2017. The December 2014 UBS facility was repaid in full. Several other financing facilities were amended or extended.
- As of August 2, 2016, management reported approximately $139 million of capital in cash or approved undrawn borrowing capacity, excluding anticipated sale proceeds and other expected cash flows. After a $10 million liquidity reserve, approximately $129 million was expected to be available for lending, share repurchases and general purposes. Management estimated potential capacity to fund approximately $450 million of additional senior loans assuming 2.5-to-1 debt-to-equity leverage.
- Subsequent to quarter-end, the Company originated three first mortgage loans with total initial funded balances of approximately $130.5 million and entered into a $125 million U.S. Bank repurchase facility, fully guaranteed by the Company.
- The Company declared a $0.26 per-share dividend for the third quarter of 2016.
- Key risks include borrower defaults, commercial real estate values, refinancing and extension risk, availability and cost of secured financing, interest-rate movements, prepayments, liquidity requirements, GSE and HUD program risk, Fannie Mae loss-sharing obligations, and the risk that the ACRE Capital sale may not close or may produce different proceeds.
- The Company had maximum quantifiable Fannie Mae loss-sharing exposure of approximately $1.1 billion, although management stated this amount does not represent the expected actual loss. The recorded allowance for loss sharing was $8.7 million.
- Management reported effective disclosure controls and no material changes in internal control over financial reporting. No material pending legal proceedings or material changes to previously disclosed risk factors were reported.
Important Facts for Investors to Verify
- Whether the proposed $93 million sale of ACRE Capital closed on the expected timetable and the final proceeds after contractual adjustments.
- Post-sale earnings, liquidity and capital allocation after removing mortgage banking operations.
- Loan portfolio credit performance, maturity extensions and the absence of impairment charges, particularly for loans maturing in 2016 and 2017.
- Availability, maturity dates, advance rates, covenants and renewal terms of secured funding facilities.
- Actual leverage relative to management’s stated target of no more than 4-to-1 debt-to-equity and the funding capacity available for new originations.
- Exposure to Fannie Mae loss-sharing claims and the adequacy of the $8.7 million allowance.
- Sustainability of the $0.26 quarterly dividend relative to recurring cash earnings and REIT distribution requirements.