Ares Commercial Real Estate Corporation — FY2017 Form 10-K Summary
Business context and reporting period
The filing covers the fiscal year ended December 31, 2017, with quarterly data for the fourth quarter included. ACRE is an externally managed specialty finance company that originates and invests primarily in commercial real estate loans. It operates as a REIT and seeks to maintain an exemption from registration under the Investment Company Act of 1940.
The company focuses on customized financing for middle-market commercial real estate borrowers. Its portfolio includes senior mortgage loans, subordinated debt, preferred equity and mezzanine loans. ACRE is managed by Ares Commercial Real Estate Management LLC, an affiliate of Ares Management, L.P.
Key financial metrics
| Metric | FY2017 | FY2016 | Change |
|---|---|---|---|
| Interest income | $97.5 million | $82.0 million | +19.0% |
| Net interest margin | $46.3 million | $45.1 million | +2.8% |
| Total expenses | $15.0 million | $14.4 million | +3.8% |
| Early extinguishment of debt costs | $0.8 million | — | Unusual 2017 charge |
| Net income from continuing operations | $30.4 million | $30.5 million | Essentially flat |
| Net income attributable to common stockholders | $30.4 million | $40.3 million | −24.6% |
| Basic and diluted EPS | $1.07 | $1.42 basic; $1.41 diluted | Lower due to 2016 discontinued operations |
| Dividends declared per share | $1.08 | $1.04 | +3.8% |
FY2016 results included $4.2 million of income from discontinued mortgage banking operations and a $10.2 million gain on the sale of that business. Accordingly, the decline in total 2017 net income and EPS is not directly indicative of weaker continuing operations.
- Loans held for investment increased to $1.73 billion from $1.31 billion.
- Total assets increased to $1.77 billion from $1.37 billion.
- Total stockholders’ equity was $419.2 million, compared with $419.0 million.
- Cash and cash equivalents were $28.3 million, compared with $47.3 million.
- The loan portfolio comprised 42 loans, with $1.74 billion of outstanding principal and a 6.3% weighted-average unleveraged effective yield.
- Senior mortgage loans represented $1.67 billion of carrying value; subordinated debt and preferred equity represented $52.1 million.
- Approximately 87.7% of loans had LIBOR floors, with a weighted-average floor of 0.79%.
Cash flow, debt and liquidity
| Metric | FY2017 | FY2016 |
|---|---|---|
| Cash provided by operating activities | $31.3 million | $8.5 million |
| Cash used in investing activities | $405.8 million | $43.3 million |
| Cash provided by financing activities | $355.6 million | $73.1 million |
| Net change in cash | $(18.9) million | $38.3 million |
| Financing Agreements outstanding | $1.07 billion | $935.7 million |
| CLO securitization debt | $271.2 million | — |
During 2017, ACRE funded approximately $900.3 million of loan principal, received approximately $400.8 million of principal repayments and sold two loans with $73.9 million of outstanding principal. As of year-end, approximately $473.0 million of committed borrowing capacity remained under the Financing Agreements, before considering lender eligibility requirements and other restrictions.
The company’s contractual obligations totaled approximately $1.18 billion, including $703.4 million due in less than one year, $460.3 million due in one to three years and $14.5 million due in three to five years. These amounts exclude variable interest expense and extension options. Unfunded loan commitments totaled $110.2 million.
All financing agreements were subject to financial and operating covenants, and management reported compliance with all financial covenants at December 31, 2017. The company targets leverage of no more than 4-to-1 debt-to-equity under current conditions, although its charter does not impose a leverage limit.
Material changes versus prior comparable period
- The loan portfolio expanded materially, with loans held for investment rising approximately 31% year over year.
- Interest income increased substantially as weighted-average earning assets grew, but higher borrowing costs limited the increase in net interest margin.
- Average borrowings increased to approximately $1.1 billion from $889.5 million.
- ACRE completed a $272.9 million CLO securitization in March 2017 and retained approximately $68.2 million of subordinate notes and preferred equity. The CLO was consolidated because ACRE was deemed the primary beneficiary.
- ACRE amended several facilities to increase capacity, reduce pricing or extend maturities, including the Wells Fargo, BAML, MetLife and U.S. Bank facilities.
- In December 2017, ACRE repaid $45.0 million of its Secured Term Loan, incurred a $0.8 million non-cash extinguishment charge, reduced the commitment to $110.0 million, lowered the spread from LIBOR plus 6.00% to LIBOR plus 5.00% and extended the maturity to December 2020.
- Management and incentive fees to the manager increased to $6.6 million from $6.0 million. Total related-party expenses were $10.8 million.
- The company’s former mortgage banking subsidiary remained classified as discontinued operations. It had been sold in 2016 for approximately $93 million.
Guidance, outlook, commentary and risks
Management characterized market conditions as favorable for disciplined direct lenders, citing active commercial real estate transaction markets and demand for shorter-duration, often floating-rate financing. Management also noted that increased competition, rising interest rates and the removal of accommodative central-bank policies could pressure asset values, financing costs and loan originations.
Management expects to continue using leverage, securitizations, secured facilities and potentially public or private debt and equity offerings to fund portfolio growth. No specific earnings, dividend or portfolio-growth guidance was provided.
- Credit and concentration risk: The portfolio is concentrated in 42 loans and lacks fixed diversification guidelines. A small number of defaults or declines in collateral values could materially affect results.
- Interest-rate risk: Most assets and borrowings are floating rate, but floors, caps, mismatched repricing and rising funding costs could compress net interest margin. The filing estimates that a 100-basis-point increase in average 30-day LIBOR would increase annual net interest margin by approximately $3.6 million, subject to portfolio composition.
- Refinancing and liquidity risk: Approximately $695.8 million of financing agreement principal was scheduled to mature in 2018 at year-end, although several facilities had extension provisions. Margin calls, collateral requirements or lender decisions could reduce liquidity.
- Loan workout items: Two loans secured by self-storage and retail properties had payment defaults before year-end and were modified in December 2017. The defaults were waived or addressed through repayments and maturity extensions. Subsequent to year-end, one related loan received a $17.4 million repayment.
- Securitization exposure: ACRE retained the first-loss position in the CLO and reported maximum exposure to loss of $68.2 million.
- REIT and regulatory status: Failure to maintain REIT qualification or the 1940 Act exemption could result in corporate-level taxes, forced asset sales or significant changes to the operating model.
- External management and conflicts: ACRE relies on its manager and pays base management fees, incentive fees and expense reimbursements. The management agreement term ended May 1, 2018, with automatic one-year renewals thereafter and a potential termination fee.
- Distributions: Quarterly dividends increased to $0.27 per share in 2017. The filing states that 2017 distributions did not exceed operating cash flow but did exceed GAAP net income. The board has not established a minimum distribution level.
Important facts for investors to verify
- Confirm the refinancing, extension or repayment status of the facilities scheduled to mature in 2018, particularly the Wells Fargo, Citibank, BAML and UBS facilities.
- Review the two modified loans with prior payment defaults, subsequent repayment activity and remaining collateral exposure.
- Assess the CLO’s retained subordinate notes and preferred equity, including the $68.2 million maximum exposure to loss and cash-flow subordination.
- Reconcile dividend coverage using operating cash flow, GAAP net income and REIT taxable income, which can differ materially.
- Monitor the effects of higher LIBOR, loan floors and borrowing spreads on future net interest margin.
- Evaluate portfolio concentration by borrower, sponsor, property type, geography and upcoming loan maturities.
- Review related-party management fees, incentive fees, reimbursed expenses and the renewal or termination terms of the Management Agreement.
- Verify subsequent-period portfolio originations, repayments, facility amendments and the declared $0.28 per-share first-quarter 2018 dividend.