Ares Commercial Real Estate Corporation — Form 10-Q Summary
Business context and reporting period
Filed August 6, 2014, for the quarter and six months ended June 30, 2014. ACRE 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 on originating, selling and servicing multifamily and senior-living loans under Fannie Mae, HUD and Ginnie Mae programs. ACRE qualifies as a REIT and generally must distribute at least 90% of REIT taxable income annually.
Key financial metrics
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Net interest margin | $10.9 million, versus $6.2 million in 2013 | $21.0 million, versus $11.5 million |
| Total revenue | $19.2 million, versus $6.2 million | $34.6 million, versus $11.5 million |
| Net income | $6.6 million, versus $3.3 million | $11.4 million, versus $3.6 million |
| Basic and diluted EPS | $0.23, versus $0.32 | $0.40, versus $0.37 |
| Dividends declared per share | $0.25, unchanged | $0.50, unchanged |
| Net cash from operating activities | Not presented for the quarter | $(42.3) million, versus $2.0 million provided |
Total assets were $1.422 billion at June 30, 2014, up from $1.177 billion at December 31, 2013. Cash and cash equivalents were $20.2 million, compared with $20.1 million. Restricted cash was $24.4 million, compared with $17.0 million.
Loans held for investment totaled $1.161 billion, up from $958.5 million. Outstanding principal was $1.170 billion, with a weighted-average interest rate of 5.4% and unleveraged effective yield of 5.9%. The portfolio consisted of 40 loans, and 74.9% of loans had LIBOR floors. Management reported that all loans were current and that no impairment charges were recorded.
Mortgage servicing rights were $58.6 million, compared with $59.6 million, and covered a servicing portfolio of 974 loans with $3.8 billion of unpaid principal balance. A 100-basis-point change in the weighted-average MSR discount rate was estimated to change MSR fair value by approximately $1.8 million.
Debt, leverage and liquidity
Secured funding agreements totaled $457.3 million at June 30, 2014, compared with $264.4 million at year-end 2013. Total commitments under these facilities were $820.0 million. Warehouse lines had $48.2 million outstanding against $185.0 million of commitments, compared with no outstanding balance at year-end.
Other debt included $68.1 million of 7.00% convertible notes due December 2015 and $395.0 million of consolidated CMBS debt. Total liabilities were $1.018 billion and stockholders’ equity was $403.8 million, compared with $406.2 million at December 31, 2013.
During the six months, financing activities provided $224.5 million of cash, including $384.9 million of secured-funding proceeds and $137.4 million of warehouse-line proceeds, partially offset by repayments of $192.1 million and $89.2 million, respectively. The company stated that it remained in material compliance with its financing covenants, including debt-to-tangible-net-worth limits and fixed-charge coverage requirements.
Unfunded principal-lending commitments were $146.5 million. ACRE Capital also had commitments to sell loans of $84.3 million and commitments to fund loans of $31.6 million.
Material changes versus the prior comparable period
- The acquisition of ACRE Capital, completed August 30, 2013, contributed $8.3 million of second-quarter mortgage banking revenue and $13.0 million for the six-month period; no comparable mortgage banking revenue was reported in the 2013 periods.
- Loan investments expanded materially, with 40 loans outstanding at June 30, 2014 versus 21 at June 30, 2013. Net interest margin increased 76% in the quarter and 82% for the six months, primarily because of the larger investment portfolio.
- Operating expenses increased to $12.5 million from $5.1 million in the quarter and to $23.8 million from $9.7 million for the six months, primarily due to ACRE Capital. Six-month compensation and benefits were $8.5 million, compared with none in the prior period.
- Basic EPS declined in the quarter despite higher net income because weighted-average shares increased substantially following the June 2013 equity offering. Six-month EPS increased to $0.40 from $0.37.
- ACRE entered into a $195.0 million UBS repurchase facility, increased the Citibank facility to $250.0 million, added a $50.0 million City National Bank facility and amended the Wells Fargo and BAML facilities.
- Operating cash flow turned negative, largely because of $151.4 million of mortgage-loan originations held for sale, partly offset by $103.0 million of loan sales.
Guidance, outlook, commentary and unusual items
Management described market conditions as favorable for disciplined direct lending, citing demand for flexible financing for transitional and value-add commercial real estate. No formal earnings guidance was provided.
The company began restructuring and relocating certain ACRE Capital support functions. It recorded $555 thousand of restructuring costs in the first six months, including $345 thousand in the second quarter, and expected approximately $340 thousand of additional costs. Completion was expected by September 30, 2014.
Subsequent events included a $29.0 million transitional loan origination, repayment of a $49.1 million loan, a new $75.0 million City National Bank facility supported by an Ares affiliate, and a planned securitization backed by approximately $378.8 million of mortgage loans. The securitization was expected to issue approximately $308.7 million of notes, but closing remained subject to customary conditions. Management expected approximately $125 million of capital, including cash and approved undrawn capacity, after the planned securitization; approximately $115 million was expected to be available after a $10 million liquidity reserve.
The third-quarter 2014 dividend was declared at $0.25 per share, payable October 15, 2014.
Key risks and contingencies
- Credit losses, defaults, collateral-value declines and weaker commercial real estate conditions could reduce earnings and stockholders’ equity.
- ACRE Capital’s Fannie Mae DUS loss-sharing exposure had a maximum quantifiable allowance of approximately $1.2 billion, although management stated this was not representative of the expected actual loss. The recorded allowance was $14.4 million.
- Rising interest rates could increase borrowing costs, pressure borrower debt service, reduce asset values and compress net interest margin. A 100-basis-point increase in average 30-day LIBOR was estimated to increase net interest margin by approximately $310 thousand for the quarter and $582 thousand for the six months, reflecting the portfolio’s asset-liability positioning.
- Funding facilities contain margin-call, collateral, liquidity, leverage and fixed-charge covenants. Refinancing risk was notable for the Wells Fargo facility’s initial December 2014 maturity and the convertible notes’ December 2015 maturity.
- MSR valuations depend on discount rates, prepayments, delinquencies and servicing economics. Mortgage banking revenue is also sensitive to loan-sale premiums and origination volumes.
- The company must maintain REIT qualification and its exemption from Investment Company Act registration. Failure to maintain REIT status could result in corporate-level taxes and other adverse consequences.
- The company is externally managed and incurred $3.0 million of management fees and $2.0 million of reimbursed general and administrative expenses during the six months.
- One principal-lending customer represented approximately 13.3% of second-quarter consolidated revenue and 13.7% of six-month consolidated revenue.
Important facts for investors to verify
- Reconcile the planned August 2014 securitization closing, proceeds, retained exposure and its effect on liquidity and leverage.
- Review maturities, extension rights, borrowing bases and covenant headroom for the Wells Fargo, BAML and convertible-note obligations.
- Monitor the $146.5 million of unfunded investment commitments and the company’s stated post-securitization liquidity.
- Assess credit performance, collateral values, loan extensions and the absence of impairment charges in light of the growing loan portfolio.
- Evaluate actual Fannie Mae DUS loss-sharing claims versus the $14.4 million recorded allowance and the $1.2 billion maximum quantifiable exposure.
- Track MSR fair-value sensitivity, prepayment rates and mortgage banking origination and sale volumes.
- Confirm completion and final cost of the ACRE Capital restructuring and relocation.
- Verify whether the company maintains REIT qualification, financing covenant compliance and the ability to sustain quarterly dividends.