Q3 2022 Ares Commercial Real Estate Corp Earnings Call
You don't have to name them welcome to Ares commercial real estate Corporation's conference call to discuss the company's third quarter 2022 financial results.
As a reminder, this COVID-19 when school is being recorded on November 2nd 'twenty 'twenty T. I will now turn the call over to Jim Steele not from Investor Relations. Please go ahead.
Yeah.
Good afternoon, and thank you for joining us on today's conference call I'm joined by our CEO , Bryan Donohoe Tae Sik Yoon, our CFO and other members of our team.
In addition to our press release and the 10-Q that we filed with the SEC. We've posted an earnings presentation under the Investor resources section of our website at Www Dot Aries CRE dot com, but.
Before we begin I'll remind everyone that comments made during the course of this conference call and webcast and the accompanying documents contain forward looking statements and 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 documents.
Ares commercial real estate Corporation assumes no obligation to update any such forward looking statements.
During this conference call, we will likely refer to non-GAAP financial measures. We use these as a measure of operating performance. These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with 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 Bryan Donohoe.
John and good afternoon everybody.
This morning, we announced third quarter distributable earnings of 39 per share an increase of 5% from the third quarter of last year, which exceeded our quarterly regular supplemental dividends paid of <unk> 35 per share.
The growth in our distributable earnings was driven primarily by the benefits of rising interest rates and some modest prepayment fees received.
Looking forward, we expect that rising interest rates will continue to have a positive impact on our earnings potential due to our floating rate loan portfolio and the hedges we have in place on our liabilities now let me touch on a few macroeconomic factors influencing our market.
The Federal reserve is continuing to tighten monetary policy with an unexpected pace of increases in market rates to combat inflation, which we believe has increased the likelihood of a recession.
These complex macro cross currents are driving volatility across most major asset classes.
<unk> commercial real estate.
Additionally, these factors are impairing capital formation as both the capital markets and bank lending has meaningfully retrenched, resulting in significantly expanded risk premiums.
We believe these conditions are likely to persist for the foreseeable future and will be challenges for our industry.
Because of all this the sourcing informational benefits and deep financing relationships that we derive as part of the Ares platform will be even more important for us in this type of environment.
We have been focused on property types, such as multifamily industrial and self storage that have strong underlying rent growth dynamics, which has muted or outpace the recent growth in market interest rates.
This has been particularly true since we exited the COVID-19 time period at the end of 2020.
In terms of deployments during the third quarter, we were highly selective.
We closed $50 million of floating rate investments across multifamily and self storage properties and $28 million of AAA rated newly issued CRE liquid debt securities.
Across both public and private market opportunities, we believe that our new investments are in property types and markets with strong underlying demand drivers.
<unk> higher rates and risk premiums, while also possessing more conservative structures and wider spreads.
By way of example, during the third quarter, we originated a senior whole loan secured by a portfolio of well located multifamily properties in the sunbelt with a well regarded repeat sponsors.
All in spread on the whole loan was 80 basis points higher than our post pandemic average fence for multifamily whole loans and with a greater equity subordination and enhanced structural terms further driving the attractiveness of the loan.
Supported by these attributes and the breadth of Ares capital markets relationships, we were able to arrange highly efficient senior financing with an insurance company on this phone with acre retaining a $26 million mezzanine investment.
We view this mezzanine investment are similar in concept to underwriting and holding a first lien loan on our balance sheet and financing a portion of the Golan with one of our nonrecourse financing sources.
We also took advantage of what we believe are compelling opportunities in the <unk> markets by purchasing $28 million of newly issued AAA rated CRE securities backed by a pool of senior floating rate mortgages.
We believe these securities are highly attractive investments with weighted average credit spreads of 245 basis points, resulting in an unlevered yields today in excess of 6% at current so for rates all backed by a diversified pool of underlying commercial real estate properties with.
With the Ltvs of 30% to 40%.
Despite the slower market, we had $167 million of repayments during the third quarter.
This level of repayments was in line with our six quarter average and included a $30 million hospitality loans.
A risk rated four loan one year ago and was repaid at par during the third quarter.
For the fourth quarter, we remain selective on new investments and expect to maintain a strong liquidity position.
Now, let me turn the call over to <unk> to walk through our quarterly financial highlights. We further details on our portfolio and capital position great. Thank you, Brian and good afternoon, everyone.
This morning, we reported GAAP net income of $644000 or <unk> <unk> per share and distributable earnings of $21 3 million or <unk> 39 per share.
The primary driver of the difference between our third quarter GAAP EPS and distributable EPS is approximately $19 5 million or about 36 per share and seasonal provision we recorded during the quarter.
This provision serve to increase our overall seats, a reserve to $51 9 million or approximately one 9% of the total commitments of our loan portfolio, which I will cover shortly in more detail.
Overall, our distributable earnings for the third quarter were supported by the positive benefits of rising interest rates and the continued contributions from our proactive approach to liability hedging that we've put in place in early 2021 when market interest rates were materially lower.
<unk> than they are today and allowed us to lock in one month LIBOR at 21 basis points.
Turning to our portfolio.
We ended the quarter with a loan portfolio consisting of 98% senior loans.
And an outstanding principal balance of $2 5 billion across 70 loans.
During the third quarter, we collected 99% of our contractual interest due.
<unk> added one new loan to non accrual status.
The three loans on non accrual status represents about 4% of our overall portfolio as of September 32022.
In terms of our other credit quality metrics, 90% of our loan portfolio had a risk rating of three or better.
Which declined from 94% last quarter and primarily reflects the negative migration of four loans during the third quarter.
More specifically the risk ratings on three loans each backed by office properties were downgraded from three to four due to our outlook on their respective business plans and our macroeconomic viewpoint of their respective submarkets.
In addition, the risk rating of one residential loan changed from four to five.
Here, we expect the sale of the underlying property in the fourth quarter below our carrying value, resulting in a loss of approximately $2 4 million should the transaction to be consummated.
In terms of our overall seasonal reserve, we increase our total reserve by $19 5 million as of the third quarter of 2022.
And our total seasonal reserve now stands at $51 9 million or one 9% of our total loan commitments.
Turning to our capitalization and liquidity our borrowing base remains highly diversified across eight various financing sources and importantly, none of these financing structures have spread based mark to market provisions.
We have received no margin calls on our liabilities.
We are also in a very strong liquidity position with approximately $156 million of available capital as of November one.
This includes cash and amounts available for us to draw under various debt facilities.
Additionally, we have $130 million of cash and our FL three securitization.
That can be used to finance new transactions at borrowing spread of L. Plus 170, a significant discount to today's market.
This healthy level of available capital should benefit us as we selectively invest in an increasingly attractive spread environment, while maintaining a significant level of liquidity due to uncertain market conditions.
Let me now provide an update on our portfolio positioning and the potential earnings benefit from future increases in short term interest rates.
98% of our portfolio as measured by outstanding principal balance is comprised of floating rate loans index to either one month, LIBOR or sulfur, resulting in our portfolio being positioned to benefit from further increases in the respective indices.
None of our LIBOR floors, which provided us with significant incremental revenues from the past two years are currently in effect.
Which means that 98% of our assets are currently sensitive to further increases in base interest rates.
In comparison as we hedge as we have hedged a meaningful portion of our floating rate debt through interest rate swaps.
<unk> borrowed on a fixed rate basis in the case of our loan in the case of our term loan.
About one third of our liabilities are not sensitive to increases in base interest rates.
Mean that Aker is well positioned to benefit from today's rising rate environment.
For example on a pro forma basis.
<unk> was 100 basis points higher than the actual September 32022 levels and all other aspects of our portfolio remained constant as of the same date.
Our annualized distributable earnings as of the third quarter of 2022 would have been higher by approximately $11 million or <unk> 20 per share on a pro forma basis.
Finally, this morning, we announced a fourth quarter 2022 regular dividend of 33 per common share as well as a continuation of our supplemental quarterly dividend of <unk> <unk> per common share.
With that let me turn the call back over to Brian for some closing remarks.
We recognize the challenges that rising interest rates and future economic uncertainty are expected to have on certain real estate properties.
We believe Ares commercial real estate remains well positioned to navigate the changing economic landscape.
Our balance sheet continues to be in great shape with moderate leverage no spread based mark to market sources of financing and a strong level of available capital.
While the competitive landscape remains highly favorable and we are finding opportunities to invest in higher yielding opportunities with better structural terms, we expect to remain highly selective.
In order to preserve our strong liquidity position during what we expect to continue to be a volatile period.
With that I'll ask the operator to open the line for questions.
Thank you.
At this time, if you would like.
To ask a question. Please press Star then one when you touched on it.
I would like to withdraw your question. Please press star one.
The first question.
On the phone lines comes from.
Steve.
Jan.
Your line is Kelly.
Thanks, Hello, everyone. Thanks for taking the question.
I am curious on the securities purchases do you as you look at that market opportunity are you looking at.
Obviously, you mentioned CBS are you also looking at Cielo is given how those.
Blown out and also the floating rate feature there just.
Curious and maybe just while and to make the response to easy also youre buying those.
Tractive rate, but are you using a bit of repo financing to get yourself to sort of a target low double digit returns.
Yeah, absolutely. Thanks for the question, Steve I think.
We actually think theres some compelling structural features within the CLO market as well so.
<unk> two were somewhat agnostic.
And you can certainly see a little bit of both.
Thus far we have not sought to lever those so.
The combination of both yield and liquidity thus far there's some features in the market that we've been hesitant to utilize leverage against.
Effectively mark to market Securities like this so thats something we have been somewhat hesitant to do and with the volatility around us.
We're exploring various structures too to mitigate some of that but it's certainly an attractive period of time to be up in the stack where spreads have candidly widened more than some of the mezzanine bonds as well.
Okay, Great and one quick follow up.
I Couldnt find the article, but I recall and looking at.
Commercial mortgage alert over the last four to five weeks.
Was a mention of sort of a resurgence in Freddie Mac Q series and I believe you've been one of the articles that referenced acre specifically and I'm just curious I know you like.
Like multifamily.
Something youre looking at.
Enhancing alternatives to to do with accusers deal with Freddie.
Yes.
Familiar with the article to date, we have not.
Explored the space, but in times of volatility that has been somewhat of a safe Harbor and also an interesting yield play.
That clearly tightened over the last five or so years to where it was less interesting to us as a broad platform not even specific to two acres.
It's not outside the realm of possibility, but not something we can explore to date.
Okay. Thank you Brian .
Thank you.
Thank you.
Your next question comes from Jade Rahmani of KD Debbie.
Ladies and gentlemen.
Thank you very much just broadly speaking in the office space do you think that it's primarily an issue of.
On liquidity.
Or lack thereof, driving these heightened.
Seasonal reserves that the commercial mortgage REIT are taking as well as in a few cases loans at maturity default or do you think there is a more fundamental reassessment of the office going on and Thats.
Adding to the valuation multiples decline that we're seeing.
Yes.
It's a good question Jade I think there is some cross currents in this space clearly we're in certain markets and in certain assets. There is just less demand on the rental side.
Thats counteracted by certain assets, where despite the volatility you've got high degrees of cash flow or longer term leases that are part of the attractive part of the office sector in times of more normal liquidity in a little bit more more equilibrium I think as I said I think there's cross currents where there.
There is some regulatory and other pressures to reduce office exposure in the banking sector.
That's flowing through and all of that contributes as your question points to towards towards how seasonal treats us.
Thank you very much.
The reserve Firstly wanted to confirm on nearly all of it was a general reserve only the $2 $4 million was launched specific but more broadly speaking could you review every loan.
And near term upcoming maturities and the risk of maturity default, there and take that into account.
Are you expecting on the loan maturity side.
Sure Jade. Thanks for that question. Yes. This is <unk>. So the answer to your first question yes.
The 19 five.
We mentioned that there was one loan that had the $2 5 million.
In terms of specifics again the change in the 19 five just to clarify was not all do that $2 five $2 five already I'm, sorry, $2 four already had a $1 five general reserve prior quarter. So that specific net change was really just the 900000.
But the remainder of the 19 five that you mentioned that is all due to this without changes in the general reserve under seasonal.
And then to answer your second question clearly one of the one of the factors that go into the seasonal model is the maturity data alone.
So when a loan is three years out versus three months out it does have a different impact on vascepa model.
He also has a impact on.
Our outlook of what that property will be performing at at the time of the maturity and obviously the closer you get to maturity the more specific in the more precise if you want to call. It we can be about it so to answer your question, yes. The maturity date is.
Taking into consideration as part of the overall seasonal reserve analysis.
Yeah.
And on the floor risk rated four bucket.
$234 million, how many loans is that and.
Over what period do you expect some kind of resolution.
Yeah.
Yes, again, if you look at the <unk>.
<unk> rated loans.
Believe there are.
There are six of them.
And in terms of.
When they will be resolved.
The good news is there is just a few that have sort of near term maturities.
But certainly all six are the focus of very intense asset management led by our team.
We are in very very close dialogue with each of the borrowers about the progress of the business plan.
Restructuring some of our loan terms if necessary.
But again I think they are all in various stages of.
Completing their business plans.
But the good news is there are a couple with some near maturities.
Those do not have near term maturities.
Our albeit very very actively pursued in terms of working very close with the borrowers to make sure that we do everything we can to work with the borrowers to meet their business plans.
Great. Thanks.
Thank you alright, thank you Jade.
The next question comes from the line of Rick Shane of Jpmorgan. Please go ahead Premier Meadowbank.
Thanks for taking my questions, everybody and I think Jade is.
Honed in on the same issue that I am which is that.
When we look at the portfolio there obviously in the next.
Three months, some pretty significant maturities and then when you extend that to six months.
And even greater.
Percentage of the portfolio is maturing.
One question and I apologize I should know this but just looking at the slide deck can't remember off the top of my head is the maturity date that you're showing the original maturity date of the fully extended maturity date.
The data we're showing is the initial maturity date.
Okay.
As we mentioned yes.
So so we shoot I'm sorry, Joe.
So we so should we assume that for most loans that are shown there with what.
What you can calculate pretty easily as a three year initial maturity probably do have at least one if not two extensions available.
Yes, I would say our standard loans do have built in mature built in extensions generally one or two one year extensions, but most often they are accompanied by some level requirements that are necessary for them to be met whether it's LTV debt yield.
<unk>.
Certainly no weakness into default potentially payment of fees different interest rates, but generally there are built in requirements about debt yields or ltvs.
Got it.
And understood that there is.
A toll that you can extract.
For those extensions and that's frankly, just part of the business is part of the business model.
Not to dismiss that when you are looking specifically at those loans within the portfolio. What's noteworthy is given the changes in the market.
And where <unk> been concentrating in terms of originations.
Proportionately.
The pending maturities are in the office space, which I think is generally speaking of greater concern right now.
Do you believe that these sponsors are in positions both financially in terms of the covenants and also from a willingness to extend or do you think that there are going to be.
Saw recently a deep Lulu.
From a competitor of yours do you think that that type of activity is just going to pick up.
So I think.
We absolutely deal with each situation's different brain I think if you look at our historical practice.
We have been very very working again very closely with each borrower to make sure. We give them every opportunity to continue to meet their business plans.
I'd say, most often we have asked for some level of concessions in order to provide.
An extension of their loans right, whether that is some sort of fee whether thats an increase in interest rate and probably most often some some material contribution of additional equity capital to show their continued sponsorship in the deal.
But again.
<unk>.
Our goal is to continuing to work with each of our borrowers to give them every opportunity for success.
<unk> committed both from an effort perspective, as well as capital perspectives.
At this point I would say there are situations, where again, it's ongoing discussions.
I don't think we have situations, where we have borrowed.
Borrowers ready to throw as the key if you want to call it that way.
<unk> certainly borrowers do behave as an economic animal.
And we do understand the situations in which they may be motivated to do so.
And so again, we evaluate each of these situations very uniquely individually it depends on the borrower depends on the building depends on the Submarket depends on so many different situations that it's hard to give a.
Generic responds.
But again I do think we do work very closely with each borrower to make sure that we have the best solution for us and for them, Yes, maybe I'll just to add onto that tastes, if I could which is another avenue.
Kind of intimated is when we do have higher cash flowing assets right and if you think about one of the benefits of office product is longer duration leases than you might see for instance in the apartment complex that additional cash flow to the extent, we're working through a period of illiquidity in the space can be rerouted through.
Cash management structure and pay down the loan or user or held as additional collateral. So.
I think tasting did a good job of covering all the different avenues in which we actively manage in the space and certainly the Mac.
The macro overlay.
It is a challenge, but one we're working through on an asset by asset basis.
Got it and look I won't make the observation.
That strategically over the decades that we followed you.
The.
Behavior has always been to work with borrowers I mean, I think there are there are and the continue AUM in terms of aggressive resolution versus really partnering.
With borrowers.
And I am not piling, which I think is better or worse.
It depends upon the lender, but I think that along history of your company is to really try to.
Work with the sponsors and keep them in the properties.
I think thats right and I, obviously at areas we.
Our DNA in credit and we know certainly have the ability across the spectrum to step into those situations in which there is value add that comes from.
The broader company expertise, but at the end of the day.
Our charter if you will is to be a lender too to these borrowers to work with them through.
Some of the cloud to your times and get get to a better environment and really maximize value at the asset level and that creates some win win situations and certainly some some brand loyalty there, but I think your take is correct.
You don't want to.
If you're running a hotel and white plains that ever again.
[laughter] not during COVID-19 at least.
Fair enough. Thank you guys.
Thanks for the time.
Thank you.
We now have Doug Harter from credit Suisse.
Please go ahead when you're ready.
Thanks can you just talk about that a.
A little bit more about the decision to allocate capital to AAA see MBS.
Kind of except obviously, a lower risk lower return.
And how that compares and how youre thinking about the timing of holding that capital versus deploying it into loans likely.
Likely higher.
Higher returns.
Yes, it was really a balance of.
Of the risk spectrum, and clearly there's been a slowdown in transaction activity throughout.
The real estate space, we're coming off of a record transaction volume year last year.
So.
Still there's still enough to do and we actually are pretty happy.
We're happy with the lending environment.
We're seeing great opportunity. So it's a fair question, we just felt the relative value to be able to.
Print those tickets when we did with the additional upside as we said on the first question about.
The potential.
To lever those if given the right structure into a <unk>.
Pretty interesting overall yield.
But the combination of the Unlevered yield plus the liquidity.
That is inherent in those securities made it something that was fairly compelling at the time again, we don't see it as changing the mandate here right, we're going to be first mortgage lenders to commercial real estate borrowers in the top markets et cetera that you've heard us talk about previously.
But at the time, given the dearth of transactions in a few of the Crosscurrents. We've mentioned we felt it was pretty compelling.
Makes sense.
And then I think you said that the CLO.
CLO or one of the CLO.
$130 million of cash what is the.
The timeframe for reimbursement or what is how much longer is there on the reimbursement rates for the CLO.
Sure. Yes, we mentioned that we have about $130 million of capacity that we could put into the CLO. This is our FL three securitization and again one of the benefits of that securitization is we've managed to extend that.
Revolving period for a number of times again really taking advantage of fact that theres really one.
One participant who holds all of the investment grade notes in that CLO.
So we still have decent amount of time to put in some additional collateral. We're still also hopeful that even when that expires. We will continue to be able to renew and I think we are right now in our third.
Revolving period, and so we do anticipate and hope that we can continue to do it but clearly we are hopeful that we can put the $130 million to work.
Very soon.
Well within the allotted time period of the replacement period.
And I guess, what limitations would there be for deployment, there or would we expect that kind of the first $130 million of loans, you do would kind of go into that CLO.
Yes, so one of the one of the limitations of course is that.
The owner of the investment grade notes has the right to approve <unk>.
Obviously worked with them over the many years to make sure that the collateral we do put that we put in CLO and <unk> three is consistent with our thesis and their thesis. So we don't see when we anticipate having challenges of identifying the right types of assets that go into it but Brian do you want to yes.
I would just add that I think the reason we set up this partnership.
A few years back was because I think we are like minded and when we speak to that investor, which we do clearly regularly and first of all I think you cited one of our true priorities is to use that liability structure given.
The in the money nature of it but we have a likeminded viewpoint on the market landscape and when we think about the opportunity set in front of us as commercial real estate lenders. They share the view that it is a very compelling time to take advantage of the dislocation. So one it's a priority for us and two it's something that we will approach.
In concert with with this partner that we've put in place for a number of years.
Thank you.
Yes.
Thank you as a reminder, if you would like to ask any further question. Please press Star then one.