Ares Commercial Real Estate Corporation: FY2013 Form 10-K Summary
Business context and reporting period
The filing covers the fiscal year ended December 31, 2013, with quarterly data including the fourth quarter. ACRE is a specialty finance company focused on originating and holding commercial real estate debt investments, including senior, transitional, bridge, subordinated and mezzanine loans. Following its August 30, 2013 acquisition of ACRE Capital LLC, the Company also operates a mortgage banking business that originates, sells and services multifamily and senior-living loans through Fannie Mae and HUD/Ginnie Mae programs.
ACRE is externally managed by Ares Commercial Real Estate Management LLC, qualifies as a REIT for U.S. federal income tax purposes, and uses taxable REIT subsidiaries for certain mortgage banking and loan-sale activities.
Key financial metrics
| Metric | FY2013 | FY2012 |
|---|---|---|
| Total revenue | $38.6 million | $6.9 million |
| Net interest margin | $28.8 million | $6.9 million |
| Mortgage banking revenue | $8.4 million | Not applicable before acquisition |
| Operating expenses | $30.8 million | $6.0 million |
| Income from operations before acquisition gain and taxes | $9.5 million | $0.9 million |
| Gain on acquisition | $4.4 million | None |
| Net income attributable to common stockholders | $13.8 million | $0.2 million |
| Basic and diluted earnings per share | $0.72 | $0.03 |
| Dividends declared per share | $1.00 | $0.67 |
| Net cash provided by operating activities | $25.4 million | $2.0 million |
FY2013 net interest margin reflected $37.6 million of interest income and $8.8 million of interest expense. Mortgage banking revenue included $5.8 million of net servicing fees, $5.3 million of gains from mortgage banking activities, a $2.7 million reduction from changes in the fair value of mortgage servicing rights, and a $6 thousand loss-sharing provision.
At December 31, 2013, total assets were $1.177 billion, including $958.5 million of loans held for investment, $89.2 million of loans held for sale and $59.6 million of mortgage servicing rights. Stockholders’ equity was $406.2 million, compared with $165.4 million at December 31, 2012.
Portfolio, liquidity and debt
- The principal lending portfolio consisted of 33 loans, with $965.4 million of outstanding principal and a $958.5 million carrying amount.
- The portfolio had a weighted-average interest rate of 5.5%, weighted-average unleveraged effective yield of 6.0%, and weighted-average remaining life of 2.5 years.
- During 2013, ACRE funded approximately $675.6 million and received approximately $66.9 million of repayments on loans held for investment.
- Cash and cash equivalents were $20.1 million, compared with $23.4 million at year-end 2012; restricted cash was $17.0 million.
- Secured funding agreements totaled $264.4 million, compared with $144.3 million at year-end 2012. Available commitments under the principal secured facilities totaled $450.0 million at year-end.
- The Company had $69.0 million principal amount of 7.0% unsecured convertible notes due December 15, 2015, carried at $67.8 million. The effective interest rate was approximately 9.4%.
- In November 2013, ACRE completed a CMBS transaction involving approximately $493.8 million of certificates, including $395.0 million of offered certificates and approximately $98.8 million retained by a wholly owned subsidiary. The transaction was consolidated as a variable interest entity.
- Year-end unfunded commitments for principal lending investments were $140.5 million. Contractual obligations and commitments totaled $581.9 million, including debt, future loan funding commitments and commitments to sell loans.
Material changes versus the prior comparable period
- Loans held for investment increased from $353.5 million to $958.5 million, while the number of principal lending loans increased from 15 to 33.
- Common shares outstanding increased from 9.3 million to 28.5 million, primarily following a June 2013 public offering of 18.6 million shares that generated $242.3 million of net proceeds.
- ACRE acquired ACRE Capital for approximately $53.4 million in cash and 588,235 common shares. The acquisition generated a $4.4 million accounting gain and contributed $9.8 million of revenue and $1.4 million of net income from the accounting effective date through year-end.
- The acquisition added a second reportable segment, mortgage banking, and increased operating expenses through compensation, servicing, compliance and other costs.
- Secured funding increased substantially, while the Capital One facility balance declined from $32.2 million to zero at year-end.
- The Company completed its first disclosed CMBS securitization, which increased both consolidated assets and liabilities but provided non-recourse financing for the securitized assets.
- The embedded conversion option liability related to the convertible notes was eliminated prospectively after stockholder approval to settle conversions entirely in shares; the $86 thousand cumulative value was reclassified to additional paid-in capital.
Fourth-quarter and subsequent developments
Fourth-quarter 2013 net interest margin was $8.6 million, mortgage banking revenue was $4.6 million, net income was $3.3 million, and basic and diluted earnings per share were $0.12. The filing states that previously reported third-quarter results were adjusted for acquisition measurement-period items and a revenue-to-compensation reclassification.
In early 2014, ACRE originated several transitional first mortgage loans totaling approximately $71.6 million of commitments, amended the BAML line of credit maturity to April 1, 2014, and closed a $50.0 million secured revolving facility with City National Bank. Management reported approximately $84 million of cash and approved but undrawn capacity as of March 14, 2014, with approximately $74 million available after reserving $10 million for liquidity requirements. The Company declared a $0.25 per share dividend for the first quarter of 2014.
Guidance, outlook, commentary and risks
- Management expected continued demand for customized CRE financing, particularly for transitional properties, refinancing needs and borrowers seeking flexible bridge or value-creation financing.
- The Company expected leverage generally not to exceed 4.0-to-1.0 debt-to-equity, although its governing documents do not impose a leverage limit.
- Management indicated that available capital and a potential 2.5-to-1.0 debt-to-equity ratio could support approximately $250 million of additional senior loan investments, subject to financing and investment conditions.
- All loans held for investment were reported as performing in accordance with their terms, and no impairment charges were recorded in 2013 or 2012.
- Key risks include borrower defaults, declining commercial real estate values, portfolio concentration, refinancing and extension risk, interest-rate and LIBOR mismatch risk, financing covenant breaches, margin or collateral requirements, and limited liquidity of CRE investments.
- ACRE Capital is exposed to Fannie Mae DUS loss-sharing obligations. At year-end, its at-risk servicing portfolio was approximately $3.7 billion, pledged collateral was $13.7 million, and the allowance for loss sharing was $16.5 million. The maximum quantifiable loss-sharing exposure was approximately $1.3 billion, although the filing states this is not a forecast of expected loss.
- ACRE Capital depends heavily on Fannie Mae and HUD approvals, multifamily loan demand, servicing relationships and GSE program requirements. Changes to the future role or structure of Fannie Mae and Freddie Mac could materially affect originations and servicing revenue.
- The fair value of MSRs is sensitive to interest rates and prepayments. A 100-basis-point change in the weighted-average discount rate was estimated to change MSR fair value by approximately $1.8 million in the opposite direction.
- The Company must distribute at least 90% of REIT taxable income to maintain REIT status. Distributions may exceed operating cash flow or earnings, and the Company may need to use borrowings, asset sales or other funding sources to satisfy distribution requirements.
- The Company relies on its external Manager and faces related-party conflicts, management fee obligations, expense reimbursements and a potentially substantial termination fee.
- Management stated that disclosure controls were effective and that internal control over financial reporting was effective excluding ACRE Capital, which was acquired during the year and represented approximately 8% of total assets and 25% of total revenue.
Most important facts for investors to verify
- Reconcile the $13.8 million of net income with the $4.4 million acquisition gain, $2.7 million MSR fair-value decline and other non-recurring or non-cash items.
- Assess the sustainability of the $1.00 annual dividend against operating cash flow of $25.4 million, required loan funding commitments and debt maturities.
- Review refinancing risk on the $166.9 million Wells Fargo balance due initially in December 2014 and the $69.0 million convertible notes due in December 2015.
- Evaluate the quality, concentration, maturity dates, extension options and collateral coverage of the $965.4 million principal lending portfolio.
- Review the assumptions supporting the $59.6 million MSR valuation, including discount rates, prepayment speeds, delinquencies and servicing costs.
- Monitor Fannie Mae DUS delinquency, loss-sharing settlements, collateral requirements and the adequacy of the $16.5 million allowance.
- Determine whether ACRE Capital integration, GSE program dependence and mortgage banking revenue generation justify the additional operating and regulatory complexity.
- Verify compliance with debt covenants, REIT asset and distribution tests, taxable REIT subsidiary limits and the Company’s exemption from Investment Company Act registration.