Ares Commercial Real Estate Corp. 2015 Form 10-K Summary
Business context and reporting period
Ares Commercial Real Estate Corporation is an externally managed specialty finance company that originates, manages and services commercial real estate debt investments. Its two reportable segments are principal lending and mortgage banking through ACRE Capital LLC. The company 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, 2015. The filing also presents unaudited quarterly data, including fourth-quarter 2015 results.
Financial performance and key metrics
| Metric | 2015 | 2014 | Change |
|---|---|---|---|
| Total revenue | $85.4 million | $65.1 million | 31% increase |
| Net interest margin | $50.0 million | $36.9 million | 36% increase |
| Mortgage banking revenue | $35.4 million | $27.6 million | 28% increase |
| Total expenses | $40.2 million | $41.6 million | 3% decrease |
| Net income attributable to ACRE | $43.3 million | $24.6 million | 76% increase |
| Net income attributable to common stockholders | $34.3 million | $24.4 million | 41% increase |
| Diluted earnings per share | $1.20 | $0.85 | Increase |
| Dividends declared per share | $1.00 | $1.00 | No change |
Revenue growth was driven by higher interest income and increased mortgage banking originations. Net interest margin benefited from $9.1 million of interest income attributable to non-controlling interests, lower weighted-average borrowing costs following financing amendments and increased leverage. Mortgage banking revenue benefited from higher loan production: ACRE Capital rate-locked 87 loans totaling $838.4 million in 2015, compared with 36 loans totaling $496.6 million in 2014.
Fourth-quarter 2015 total revenue was $20.9 million, net income was $11.1 million, net income attributable to common stockholders was $8.9 million and diluted earnings per share were $0.31.
Balance sheet, portfolio, cash flow and liquidity
- Total assets were $1.379 billion at December 31, 2015, down from $1.862 billion at December 31, 2014, primarily reflecting loan repayments and lower loans held for sale.
- Loans held for investment were $1.174 billion, compared with $1.463 billion at year-end 2014. The principal lending portfolio excluding third-party non-controlling interests consisted of 38 loans with $1.134 billion of outstanding principal and a 6.0% weighted-average unleveraged effective yield.
- Senior mortgage loans represented $961.4 million of carrying value; subordinated debt and preferred equity represented $166.4 million. All loans were current under their contractual terms, and no loan impairments were recorded in 2015, 2014 or 2013.
- Mortgage servicing rights were carried at fair value of $61.8 million, up from $58.9 million. The servicing portfolio comprised 973 loans with approximately $4.9 billion of unpaid principal balance.
- Financing Agreement borrowings were $622.6 million at year-end, compared with $746.0 million in 2014. Securitization debt was $255.3 million, compared with $527.7 million of outstanding principal in 2014. The company also had $75.0 million drawn under a new secured term loan.
- Total liabilities were $922.5 million and total equity was $456.5 million. Stockholders’ equity was $409.5 million.
- Cash and cash equivalents were $9.0 million, supplemented by restricted cash of $30.4 million. As of February 26, 2016, management reported approximately $170 million of capital in cash or approved but undrawn borrowing capacity, or approximately $160 million after reserving $10 million for liquidity requirements.
- Net cash provided by operating activities was $275.5 million, compared with cash used of $222.9 million in 2014. Net cash provided by investing activities was $258.3 million, while financing activities used $541.4 million. Cash and cash equivalents declined by $7.6 million during 2015.
Material changes versus the prior comparable period
- Net interest margin increased by $13.1 million, primarily from non-controlling interest income, lower financing costs and greater leverage.
- Mortgage banking revenue increased by $7.8 million, led by higher gains from mortgage banking activities of $27.1 million versus $17.5 million.
- Operating expenses declined by $1.4 million as restructuring-related general and administrative costs and professional fees decreased, partially offset by higher compensation and commission costs at ACRE Capital.
- Loans held for investment declined by $288.2 million. During 2015, the company funded approximately $229.9 million of principal, received approximately $410.6 million of principal repayments and sold a $75.0 million loan without recognizing a gain or loss.
- The company repaid the $69.0 million principal amount of its 7.00% convertible senior notes at maturity in December 2015.
- The company entered into a $155.0 million secured term loan in December 2015 and initially drew $75.0 million. The loan bears interest at LIBOR plus 6.00%, subject to a 1.00% LIBOR floor, and matures in December 2018.
- ACRE Capital’s allowance for loss sharing declined to $9.0 million from $12.3 million. Its estimated at-risk balance under Fannie Mae’s DUS program was approximately $1.1 billion, within a $3.2 billion risk-sharing portfolio.
Outlook, commentary, risks and unusual items
Management characterized market conditions as favorable for disciplined direct lending, citing demand for customized, shorter-duration and floating-rate CRE financing and substantial commercial real estate debt maturities expected over the following three years. No formal earnings or revenue guidance was provided.
Management indicated that, after liquidity reserves, the company could potentially fund approximately $560 million of additional senior loans assuming $160 million of available capital and leverage of 2.5-to-1. This is a capacity illustration, not a commitment or forecast.
- Interest-rate risk is significant because borrowing costs are largely floating-rate. Management estimated that a 100-basis-point increase in average 30-day LIBOR would have increased 2015 net interest margin by approximately $2.1 million, although actual effects depend on asset and liability composition, floors, caps and hedges.
- Portfolio concentration, borrower defaults, declining real estate values, refinancing risk, illiquidity and prepayments could reduce earnings, asset values and distributions.
- Financing agreements contain leverage, liquidity, fixed-charge coverage, asset coverage, collateral and distribution covenants. The company reported compliance in all material respects at December 31, 2015, but defaults could trigger acceleration, margin requirements or foreclosure.
- The company had approximately $98.3 million of unfunded principal lending commitments, $237.4 million of commitments to sell loans and $207.6 million of commitments to fund mortgage banking loans at year-end.
- ACRE Capital is exposed to Fannie Mae, Freddie Mac and HUD program requirements, risk-sharing obligations, loan repurchases, servicing advances and possible loss of agency approvals.
- The company is externally managed and paid $5.9 million of management fees and $3.9 million of reimbursed general and administrative expenses in 2015. No incentive fee was earned in 2015, 2014 or 2013. The management agreement was scheduled to expire May 1, 2016, subject to automatic renewal provisions and potential termination fees.
- Following the January 9, 2016 death of an independent director, the company was temporarily not in compliance with the NYSE requirement that a listed company have a majority of independent directors. The NYSE gave the company until July 9, 2016 to resolve the issue.
- Subsequent events included a $56.0 million first mortgage loan originated in January 2016, extensions or amendments to certain credit facilities, an increase in the stock repurchase authorization from $20 million to $30 million, and a first-quarter 2016 dividend declaration of $0.26 per share.
- There were no material pending legal proceedings as of December 31, 2015, and management concluded that disclosure controls and internal control over financial reporting were effective.
Most important facts for an investor to verify
- Reconcile reported net income attributable to common stockholders of $34.3 million with quarterly earnings, dividends declared and cash available for distribution.
- Review the composition, maturity schedule, collateral quality and concentration of the $1.1 billion principal lending portfolio, including loans maturing in 2016 and 2017.
- Assess refinancing, margin-call and covenant risk on the $622.6 million of Financing Agreement borrowings and $255.3 million of securitization debt.
- Evaluate the sustainability of mortgage banking revenue, MSR valuations and ACRE Capital’s Fannie Mae DUS loss-sharing and repurchase exposure.
- Confirm post-year-end liquidity, undrawn borrowing capacity, unfunded commitments and the assumptions underlying the illustrative $560 million lending capacity.
- Monitor interest-rate sensitivity, LIBOR floors, hedging effectiveness and the effect of higher short-term rates on net interest margin.
- Verify continued REIT qualification, 1940 Act exemption, NYSE independent-director compliance and the terms or renewal status of the external management agreement.