Ares Commercial Real Estate Corp

NYSE:ACRE

Earnings Call Transcript

[Operator]

Good afternoon, ladies and gentlemen. Welcome to Ares Commercial Real Estate Corporation's Second Quarter Earnings Conference Call. [Operator Instructions]. And as a reminder, this conference is being recorded on Tuesday, August 6, 2024. I will now turn the call over to Mr. John Stilmar, Partner of Public Markets Investor Relations. Mr. Stilmar, please go ahead.

[John Stilmar, executive]

Good afternoon, and thank you for joining us on today's conference call. In addition to our press release and the 10-Q that we filed with the SEC, we put an earnings presentation under the Investor Resources section of our website at www.arescre.com. Before we begin, I want to remind everyone that comments made during the course of this conference call as well as webcast and the company documents contain forward-looking statements that are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may and similar such expressions.

These forward-looking statements are based on management's current expectations of market conditions and management's judgment. These statements are not guarantees of future performance, condition or results and involve a number of risks and uncertainties. The company's actual results could differ materially from those expressed in the forward-looking statements as a result of a number of factors, including those listed in its SEC filings. Ares Commercial Real Estate Corporation assumes no obligation to update any such forward-looking statements. During this conference call, we will refer to certain non-GAAP financial measures. We use these as measures of operating performance, and measures should not be considered in isolation from or as a substitute for measures prepared in accordance with the generally accepted accounting principles. These measures may not be comparable to like titled measures used by other companies. Now I'd like to turn the call over to our CEO, Brian Donahoe. Brian?

[Bryan Donohoe, executive]

Thank you, John, and good afternoon, everyone. Before we begin a review of our second quarter 2021 results, I wanted to take a moment to congratulate Tae-Sik Yoon as our new Chief Operating Officer; and Jeff Gonzales as our new Chief Financial Officer and Treasurer. Both of these appointments will be effective as of August 30, 2024. As you know, both Tae-Sik and Jeff have been long-term members of our management team with Tae-Sik having joined in 2012 and Jeff in 2013. Tae-Sik will continue to help execute our strategic goals, partnering with our debt capital markets team to further bolster the strength of our balance sheet and working with our asset management team.

During the past 11 years, Jeff has worked closely with Tae-Sik and our senior management team, serving in various finance roles, including as our controller since 2015. Jeff's financial expertise long tenure at ACRE and deep understanding of our company and portfolio are highly valuable and make Jeff a natural choice as our next CFO. So with that, let me give some brief comments on market conditions and how we believe these trends are impacting our financial results and positioning of our balance sheet. Commercial real estate market sentiment is modestly improving, driven by reduced interest rate expectations, future supply dynamics and the amount of capital available to be invested from the sidelines. While these positive dynamics are pointing to increased activity levels and the potential bottoming of CRE values more broadly, sales activities and financing of properties remains dynamic.

These trends are impacting the timing of exits and resolutions, which, in turn, informs our strategy and impacts our near-term earnings. As one example during the second quarter, the anticipated sale of a multifamily property securing one of our senior loans did not move forward as anticipated. Given the uncertainty around the ultimate execution in the sales process, we put the loan on nonaccrual and revised the risk rating from a 4 to a 5. However, subsequent to the end of the second quarter, the property has since gone under contract for sale with a hard deposit, increasing the likelihood of a near-term resolution. Due to this variability in the market, our strategy is to maintain significant levels of liquidity and to further reduce leverage.

Our focus on strengthening our balance sheet in order to drive maximum flexibility in addressing our underperforming loans results in uneven and below potential levels of earnings. Upon resolution of these loans, we expect the company will be positioned to invest further and return to a higher level of profitability. During the second quarter, we saw no negative migration in our risk rated 1 to 3 loans. These [ 35 ] loans account for about 3/4 of our total $2 billion loan portfolio. Furthermore, the underlying borrowers have committed approximately $140 million of capital over the last 12 months in support of the risk rated 3 or better loans. Now turning to our risk rated 4 and 5 loans. We ended the second quarter with 7 loans totaling approximately $477 million of outstanding principal.

In the second quarter, we took title to a California office property that was previously financed by a $33 million risk Grid 5 loan and was on nonaccrual at March 31, 2024. In conjunction with this, we recorded a realized loss of $16 million and classified the property as REO held for sale. Also, during the second quarter, Three loans migrated from a risk rating of 4 to a risk rating of 5. These loans are comprised of the multifamily loan I mentioned earlier, on $69 million office loan in North Carolina, and $120 million senior loan in California. We are focused on addressing all 3 of these loans, which would significantly reduce the balance of risk rated 4 and 5 loans.

With that, I'll turn the call over to Tae-Sik, who will provide more details on our second quarter earnings and capital position.

[Tae-Sik Yoon, executive]

Thank you, Brian. I too want to take a moment and congratulate Jeff Gonzalez as our new CFO, and Jeff and I have worked together for many years and look forward to our continued partnership. For the second quarter of 2024, we reported a GAAP net loss of approximately $6.1 million or $0.11 per common share. Our distributable earnings loss for the second quarter of 2024 was approximately $6.6 million or $0.12 per common share and was driven by a realized loss of $16.4 million or $0.30 per common share upon taking title to the California office property as REO that Brian mentioned. Distributable earnings, excluding the realized loss of $16.4 million or $9.8 million or $0.18 per common share for the second quarter.

Our overall CECL reserve now stands at approximately $139 million, about $2 million less than the approximately $141 million reserve as of March 31, 2024. This reduction was driven by a $15 million reversal of an existing reserve associated with the realization of loss that was incurred on the California office property. The overall CSR reserve of approximately $139 million at quarter end represents about 7% of the outstanding principal balance of our loans held for investment. Our total CECL reserve are around $125 million relates to our risk rated 4 or 5 loans, representing approximately 26% and of the $477 million in outstanding principal balance of risk rated 4 and 5 loans held for investment.

As Brian mentioned, we continue to take appropriate steps with our balance sheet to maintain financial flexibility in order to support our strategic priorities. We believe that operating at lower leverage and maintaining higher levels of liquidity in the near term, best positions the company to maximize resolutions of underperforming loans and advance the long-term objectives of our company.

Finally, we declared a regular cash dividend of $0.25 per common share for the third quarter of 2024. The third quarter dividend will be payable on October 15, 2024, to common stockholders of record as of September 30, 2024. And with that, I will turn the call back over to Bryan for some closing remarks.

[Bryan Donohoe, executive]

Thanks, Tae-Sik. As we've discussed, we are intently focused on executing on the goals of [indiscernible] risk rated 4 and 5 loans which we believe will ultimately lead to the resumption of new investment activity, portfolio growth and a higher state of profitability. In the near term, we're taking what we believe are the necessary steps towards bringing further certainty to the ACRE portfolio and book value. As always, we appreciate you joining our call today, and we'll be happy to open the line for questions.

[Operator]

We'll go first this afternoon to Shane Rick of JPMorgan.

[Richard Shane, analyst]

I don't know who that is, but we'll give this a try. Good morning, everybody. Yes. I guess I've been called worse. Anyway, look, and this is a question we've been asking to some of your peers as well. conditions are changing very quickly. Outlook has changed radically just based upon the shape of the forward curve. Some of what dictates behavior is obviously fundamental but a lot of it is sentiment driven. Are you -- how quickly are you seeing behavior from borrowers change, their outlook changing, their willingness to work with you resolve loans and try to hold on the properties just given the better expectations in terms of the forward curve.

[Bryan Donohoe, executive]

Yes, it's a great question, Rick. And I think the optimism is starting to crystallize with rates, but you really started to see that creep back into the market beginning around the holidays last year in Q4. And if you listen to the Ares management investor presentation, I think we noted about 2x the real estate activity year-over-year increase. And I think that's reflective of some of that change in sentiment and the rate movement, certainly the -- I mean, we have pretty volatile markets over the last week, all of which may inerts the benefit of real estate values with the backdrop that we touched on in the prepared remarks of declining cost of funds and cost of capital alongside a supply story that starts to be more accretive to long-term value.

So I don't know that the last month or so of the decline has yet fully crystallized in terms of the market, but the sentiment is out there and the behaviors are changing in real time, and I think should all move directionally positive.

[Operator]

We'll go next now to Stephen Laws of Raymond James.

[Stephen Laws, analyst]

First, I kind of want to think about -- it sounds like the portfolio is probably going to continue to run off a little bit and leverage is down, but that does -- may or may not mean earnings go the same way. So as I think about when distributable earnings ex losses are going to trough. Can you talk about the things that will move the needle there, whether it's the financing on nonaccrual assets, potentially new loans to help facilitate a resolution kind of how do we think about the earnings trough even given a declining portfolio size.

[Tae-Sik Yoon, executive]

Sure. Thanks very much for your question, Stephen. Chad, it's a great question in terms of what are the drivers of our current earnings. Certainly, as Bryan mentioned and as we have mentioned in our remarks, for this call and in prior calls, we've been very purposeful in maintaining financial flexibility. We've been very purposeful in delevering the balance sheet. We've been very purposeful in making our overall asset size smaller as well as maintaining higher levels of liquidity. All of that has obviously had its impact on earnings.

The other thing that has had a big impact on earnings are the number of loans that we put on nonaccrual, including, for example, putting on nonaccrual, this $97.5 million multifamily loan that Bryan mentioned in our call. Each of those activities obviously has a big movement in our earnings. But as we said, as we continue to resolve these 4 and 5 risk-rated loans, and we're able to either pay down debt associated with those assets. And many of those assets are in nonaccrual. We're not recognizing interest income from those. But as we resolve these risk rated 4 and 5 loans and we pay down debt, we potentially utilize that cash for other purposes. Again, I think that can start to have a positive impact on earnings.

I think one of the things that Brian mentioned is that we do expect to have uneven earnings as we work through our strategic plan. Our current earnings, as Brian also mentioned, are below potential levels of earnings. So your question is a great one. I do think there's a lot of different things that are going to move the earnings. And we're hopeful that as we resolve these loans and get ACRE back into the business of investing in new loans and earning net interest margin that we will be able to stabilize and increase our earnings on a go-forward basis.

[Stephen Laws, analyst]

Great. And to follow up on that, the current -- you declared the dividend for Q3 and the current run rate annualized is about a 9.5% return on book value. Are you still feel comfortable with that as you look at longer-term earnings potential of the portfolio on a run rate earnings basis?

[Tae-Sik Yoon, executive]

Yes. I think our Board declared the $0.25 dividend for the third quarter, and that was based upon obviously, a review of our current financial position, our balance sheet, the outlook. But as we've said, we do think, again, we will have some unevenness in our earnings based upon the strategic activities that we're pursuing. As always, the markets will also impact our earnings going forward in terms of the commercial real estate market in terms of interest rate, other macroeconomic factors.

So I think our Board will continue to evaluate our dividend on a quarter-by-quarter basis, take all the business consideration. As we've said, we do believe that the market is variable right now, both in terms of certainty and timing. So we'll continue to evaluate our dividend and the Board will make these decisions on a quarter-by-quarter basis.

[Stephen Laws, analyst]

Great. And then last question for me regarding the new vibrated multifamily asset that went on nonaccrual. I guess, two parts. How much did the -- how much interest income did it contribute in Q2. And then assuming the sale that it's under contract now, how much of a realized loss should we expect to flow through the third quarter distributable earnings?

[Tae-Sik Yoon, executive]

Sure. So for the second quarter, we did not recognize any income, any interest income from this multifamily loan. So it was on nonaccrual for the entirety of the second quarter. As you can see, sort of one indicator of -- thought we did actually receive interest income, again, but we did not recognize it as interest income. We did it as cost recovery. And so one of the things you can see is that the carrying value of this loan did go down from the outstanding principal balance to its carrying value by about $2 million.

So that gives you an approximation of how much interest income was received but not recognized as revenue or income. And then in terms of the loss we potentially could recognize, I think if you look at our 10-Q, you'll see that we have about a $6.5 million CECL reserve against this multifamily loan. Again, just given the sensitivity of it being under contract, I don't think we should be more specific. All of that happened post quarter end. But as of 6/30, you can see we had about a $6.5 million CECL reserve against this multifamily loan.

[Operator]

We'll go next now to Jade Rahmani at KBW.

[Unknown Analyst]

This is actually Jason Sachin on for Jade. What dollar value of REO do you ultimately expect? And where do you think book value per share might trough?

[Bryan Donohoe, executive]

I had a tough time hearing the beginning of that question.

[Unknown Analyst]

Yes, I said what dollar value of REO do you ultimately expect and where do you think book value per share might trough?

[Bryan Donohoe, executive]

So if I understand the first part of the question, it's how much REO ultimately do you expect to see within the portfolio?

[Unknown Analyst]

Yes.

[Bryan Donohoe, executive]

I think it's tough to predict. Obviously, we have active dialogue with each of our borrowers and the primary charge of the company is to work through those discussions. And to the extent that we're seeing value added by the sponsor, either operationally or financially, we'd like to keep everybody in their natural seat. There are situations where we do find that we, as a large operator of real estate can add significant value in certain situations. And obviously, those are times when we will step in to those assets. And I think that's an important arrow available to us. So it would be tough to put a finite point on the amount, but it's something that, to the extent we do step in you will likely see [ stood ] for a short duration of time as we stabilize assets and return them to, I'll say, rightful ownership in the equity side of the ledger.

[Unknown Analyst]

Great. And as a follow-up, what would drive migration from risk 4 to 5 in some loans? And are there any loans in particular that you're monitoring more closely?

[Bryan Donohoe, executive]

I'd say -- I'll let Tae-Sik walk through some of the technical components of risk rating definition. But our asset management team is very well built out, and our monitoring is applied to every single asset in the portfolio, taking into account both financial results, our sentiment interest rate environment and the like. So all of the factors that would come through that viewpoint are taken into account as we think through those risk ratings. And Tae-Sik, maybe you can just give the definition.

[Tae-Sik Yoon, executive]

Yes. Again, I think that when you kind of look through our public disclosures, you'll see some more definitive definitions of what our risk ratings entails. So I would encourage you to look at that. But maybe just to summarize and try to address your question of what would drive a 4 versus 5. Again, there's a multitude of factors, but some of the factors would include kind of the certainty and timing. So for example, if you have a loan that doesn't mature for 2 years versus a loan that has already matured or has a very short-term maturity obviously, the shorter-term maturity would increase the likelihood of a potential event, and that would be factored in as well as the likelihood of a loss. So it's really a combination of a multiple of factors. But I would say, again, the timing and certainty of loss as that increases, there's potential migration therefore, from a 4 to a 5.

[Operator]

We'll go next now to Doug Harter at UBS.

[Unknown Analyst]

This is actually Will Masson for Doug today. I actually have a similar question on credit migration, the last one. I was hoping you could walk us through your confidence level and the current pace of credit migration. Just looking at balancing resolutions versus development of new problem assets going forward?

[Bryan Donohoe, executive]

Yes, it's a good question. I think we touched on in our remarks in our first question there around the overall market sentiment. If you look at the scale of our portfolio relative to the entire real estate industry, right, we're a very small portion of that. So the positive sentiment is certainly the right backdrop and a backdrop we're appreciative of having had its multuous 24-odd months here. I think we're seeing stability in underlying fundamentals of the assets.

I think as a catalyst, the change in rates is making it more likely for borrowers to continue to invest in their assets, just that change in the cost of funds. So as we touched on no migration from the 1 to 3 assets and small migrations within the 4 and 5. And we're certainly focused on resolving those appropriately in the near term. So I think the backdrop is supportive of continued stability in the portfolio.

[Operator]

[Operator Instructions]. We'll go next now to Chris Muller with Citizens JMP.

[Christopher Muller, analyst]

Congrats to Tae-Sik and Jeff on the new roles. So I guess my question is, what would it take for you guys to get back on offense? Is it more working through some of the problem loans or is it more Fed and sediment driven? And do you think that could be a back half of the year type thing or more 2025 type of that?

[Bryan Donohoe, executive]

Yes. Good question, Chris. I think ultimately, we're as you saw and as you heard, there remains some uncertainty out there and the unevenness of the earnings profile is such that it keeps us thinking through, not out of the woods yet, but certainly starting to see additional light come through. And I think that stability, I mentioned on the prior answer is a part of that. look, we've got a team that is at the ready to go on offense.

We're seeing increased transaction activity broadly in the market. So we're excited by the prospects of getting back out there. but we want to make sure that we're doing so with sound footing. So the focus will remain on resolving those assets, bringing additional clarity to the book. And then we have a team that's, as I said, ready to go once we brought that clarity to our stakeholders.

[Christopher Muller, analyst]

Got it. That's helpful. And then maybe staying on the asset management side of things. So of that $140 million of equity contributions from borrowers I guess what is that going towards? Is it renewing rate caps, loan paydowns, reserve replenishment or maybe a combination of all those?

[Bryan Donohoe, executive]

It's a combination. So think about -- and I think part of the positive attributes of the movement in the interest rate curve is that some of that money in the next iteration of it will be reallocated from carry and interest rate caps and be more to accretive spends like CapEx projects and tenant improvement dollars. So as we've seen stability in even the office leasing market and slight upticks in the demand side there, those TI packages have gotten more expensive.

So it is an important attribute that sponsors are continuing to invest in their assets. So it runs the gamut from carry to caps to renovation projects and certainly tenant improvement dollars that will be long-term value creators at the underlying asset level.

[Operator]

And gentlemen, it appears we have no further questions this afternoon. Mr. Donahoe, I'd like to turn things back to you for any closing comments.

[Bryan Donohoe, executive]

Thank you, and thanks, everybody, for joining today, and thank you to the entire team for all work this quarter, and we look forward to speaking again in the near future. Thanks for the time.

[Operator]

Thank you, Mr. Donahoe. Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately 1 hour after the end of this call through September 6, 2024 to domestic callers by calling 1 [phone] and to international callers by dialing [phone]. An archived replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website. Again, thanks for joining us, everyone. We wish you all a great day. Goodbye.