Q4 2022 Ares Commercial Real Estate Corp Earnings Call
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Yes.
Hello, and welcome to today's AC Ari Q4, 'twenty two earnings conference call. My name is fading and I'll be the operator for today's call.
All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end.
If you would like to ask a question. Please press star followed by one on your telephone keypad.
It's possible, but you are right John Zillmer. Please go ahead when you're ready.
Good afternoon, and thank you for joining us on today's conference call I'm joined today by our CEO , Bryan Donohoe, and our CFO tooth again in.
In addition to our press release and the 10-K that we filed with the SEC.
Most of the earnings presentation under the Investor Resources section of our website at Www Dot Aries CRE dotcom.
Before we begin I want to remind everyone that comments made during the course of this conference call and webcast as well as 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.
Payments are not guarantees of future performance condition or results and involve a number of risks and uncertainty.
The company's actual results could differ materially from those expressed in forward looking statements as a result of a number of factors, including those listed in its SEC filings Ares commercial real estate assumes no obligation to update any such forward looking statements.
During this conference call, we refer to non-GAAP financial measures. We use these measures of operating performance and the measure should not be considered in isolation from or 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.
I would like to turn the call over to our CEO Bryan Donohoe, Thanks, John and good afternoon everybody.
This morning, we reported fourth quarter results, which included the second highest level of quarterly distributable earnings in our history, a 44 per share.
And capped off a strong year.
Annual distributable earnings of $1 55 per share matched our previous record in 2021.
Throughout 2022, the overall strength in our distributable earnings was driven primarily by the continued benefits of our nearly 100% floating rate interest rate sensitive asset base.
In addition, we hedged or fixed approximately a third of our liabilities.
2022 was a very successful year in which we fully covered our regular and supplemental dividends from distributable earnings at 110%.
In addition, we made a conscious decision to bolster our liquidity and further strengthen our balance sheet throughout much of the year.
While our strong distributable earnings benefited from the tailwind of higher interest rates. The same higher interest rates have also led to some headwinds for the overall commercial real estate market.
Specifically, we're seeing many property owners take a pause on executing business plans as they adjust to these historic increases in market interest rates.
At the same time certain markets are experiencing weaker leasing and occupancy trends.
As has been well publicized office market in particular is facing challenges from shifting demand in a post pandemic economy.
Although we believe our senior loan oriented portfolio has been carefully constructed.
We arent immune to the effects that these market headwinds present.
As you'll hear from basic these industry wide movement have resulted in higher credit reserves.
Greater number of loans and defaults were on nonaccrual status and elevated that's great.
We are very focused on maximizing the outcomes for these situations and we believe we are well equipped to handle them.
It's important in the context of these broader industry headwind to take a minute to review our positioning and capabilities.
In areas. We believe we have a demonstrated playbook on navigating volatile markets and capitalizing on illiquid environments.
Our approach during these periods is first and foremost to operate with additional liquidity, while keeping an eye towards opportunistic investments.
The Ares real estate group has over $51 billion of assets under management.
More than 2000 properties globally managed by over 240 investment professionals.
This provides significant advantages to acre, helping understand markets and then tapping into extensive asset level experience.
These insights to shift into a more defensive posture in 2022 and puts us in a better position to navigate a more complex real estate market going forward.
Our overall liquidity was enhanced by $823 million in principal loan repayments during 2020 to a new record for our company.
In addition to these loan repayment, we realized more than $38 million of proceeds from the sale of the Westchester Marriott in the first quarter of 2022.
This was a property, where we became the owner in 2019 successfully navigated operationally through Covid and executing the business plan for the property.
This led to a positive return through the total life of the investment and highlights one of the many ways. We can achieve successful outcomes with the property operating below plan.
In terms of our investment activity. During 2022, we originated $725 million of new loan commitments with more than a third of exceptional commitments in the multifamily sector.
Additionally, we invested opportunistically in AAA securities backed by a diverse pool of underlying loans.
Looking forward very significant uncertainty regarding the commercial real estate market and property values.
Our focus will be to resolve certain situations to maximize outcomes.
While prudently deploying capital into attractive new investment opportunities.
We believe our liquidity and property level expertise position us well to successfully navigate and ultimately capitalize on the current environment.
With that let me now turn the call over to <unk> to walk through some of our financial highlights and further details on our portfolio and capital position.
Great. Thank you, Brian and good afternoon, everyone.
For the fourth quarter of 2022, we reported GAAP net income of $2 9 million or five cents per common share and.
And distributable earnings of $23 9 million or <unk> 44 per common share.
For full year 2020 to GAAP net income was $29 8 million or <unk> 57 per common share.
Distributable earnings were $80 7 million or $1 55 per common share.
For full year 2022, similar to 2021, we more than fully covered our dividends through distributable earnings at 110% as we continued to build on our long term track record of having distributable earnings per share.
Both the regular and supplemental dividends.
Most notably we have delivered a consistent and growing dividend throughout the life of our company with no history of dividend reductions or delays.
Turning to our asset base, we ended the quarter with a loan portfolio consisting of 98% senior loans.
And an outstanding principal balance of $2 3 billion.
Supplied across 60 loads.
During the fourth quarter, we collected 99% of our contractual interest yet in terms of our other credit quality metrics, 80% of our loan portfolio had a risk rating of three or better.
It's declined from 90% in the third quarter of 2022.
This change primarily reflects the negative migration of one office property alone.
And one mixed use property alone.
Which were downgraded from three to four due to our outlook on their respective business plans and our macroeconomic view of their respective submarkets.
As it relates to seasonal we increased our total reserve by $19 4 million during the fourth quarter of 2022.
And our total seasonal reserve stands at $71 3 million or about 3% of our total loan commitments at year end 2022.
Shifting to post quarter end activity.
In January 2023.
We successfully resolved a senior loan backed by a residential property located in California.
Through our structuring capabilities and experience of our asset management team we.
We were able to recover approximately 98% of our cumulative cash investment in as well.
On a GAAP basis, we expect to take a $5 6 million realized loss.
In the first quarter of 2023.
However, as we had held a specific reserve on this loan as of year end 2022 in.
In the same amount, we do not expect any material net GAAP loss in the first quarter of 2023 in connection with the resolution of this loan.
This loan was our only risk rated five asset at year end 2022.
Since year end 2022.
And by some of the broader market dynamics that Brian mentioned earlier.
Three additional senior loans experience maturity default.
Clothing to loans backed by mixed use properties and one loan collateralized by an office property.
While we have different paths or pursue for each of these three loans.
Our asset management team is highly engaged with a goal of maximizing the financial outcomes of each situation.
Our confidence stems from our experience and capabilities in managing underperforming situations.
The strength of our balance sheet.
It should provide us flexibility and liquidity as we seek to maximize outcomes.
We remain in a very strong liquidity position with more than $200 million of available capital as of year end 2022.
Including cash and amounts available for us to draw on our revolving debt facility.
And our debt to equity ratio of 2.1 times a.
Amongst the lowest of our peer group.
By just additional balance sheet strength and stability.
Finally.
This morning, we announced a first quarter 2023 regular dividend of <unk> 33 cents per common share.
As well as a continuation of our supplemental quarterly dividend of <unk> per common share.
And with that let me turn the call back over to Brian for some closing remarks, that's great. Thanks Tae sik.
Despite rapid changes in interest rates and significant volatility across credit markets in 2022 acre delivered compelling distributable earnings and strong dividend coverage.
We believe there are three key factors that helped us successfully navigate this environment and position us positively for 2023.
The first is the strong operating capability of our platform and property level expertise.
The second is our low levered balance sheet with strong liquidity position.
And the third is our use of non mark to market.
Let me close by saying that we are deeply grateful to our investors for the trust and confidence they have demonstrated in areas and they are supportive of the company.
I'd also like to thank our entire team for their hard work and dedication in 2022 and with that I'll ask the operator to open the line for questions. Thank you.
Thank you.
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Our first question today comes from the line of Steve Delaney from JMP Securities. Please go ahead. Your line is now open.
Thanks, Hello, everyone I appreciated your comments.
To start off with.
Notice that the portfolio did actually shrink fairly meaningfully in the first quarter. I think you had 56 million of originations and a little over 300, a prepays. So a net of about 200 and the shrinkage is 263, so that was 11% of the portfolio. So as we think about that I know you know things can be chunky and it can be anomalies.
Looking out.
You know to mid 2023 or even the end of 2023 were in this more cautious period should we from a modeling standpoint expect some continued shrinkage or is it your goal to try to maintain the portfolio at relatively close to the current size. Thank you.
Yeah. Thanks for the question, Steve and I'll I'll get started and then tastes. It can obviously it jumped well I think.
I don't I wouldn't point to that has enough of a data set to identify I think overarching we sit here today and what we believe is a pretty enviable position of having liquidity both to be defensively positioned for assets that will need some capital as well as two to attack an environment that is key.
Candidly one of the one of the Paas relative values, our highest relative values that we've seen in.
In the past couple of cycles, so I.
I don't think it's it's something to point out to you that we expect the portfolio to continue to shrink, but I'd, rather we're positioned to take advantage of idiosyncratic risk positions.
Very fruitful market.
That might be a great lead into.
My next question you know we noticed that you made just one new loan of $56 million, but given the backdrop and all the chatter about office, maybe we were a bit surprised to see that the one loan that you chose to make in the quarter. You know it was an office property in the upper mid West does this tie into your comments about being offered.
And you stick.
What caused you guys to think that's an attractive investment for your loan portfolio. Thanks, Brian .
Yeah, absolutely I think.
We noted the headwinds in office and I think we could we've spent plenty of time debating that really as an industry group right I think that's right.
Certainly assets and the cash flow profile of this building.
Continued cash infusion by the bar it made it an attractive risk.
The risk return.
For us, but as we've touched on in prior quarters, I don't think you're going to see generally our office footprint increase over time, but there are one off asset situations that are attractive as you continue to see industry wide I think the headwinds are not insignificant, but that doesn't mean, there aren't assets that will be fixed.
Yes.
Got it thanks for the comments.
I appreciate it.
Thank you.
The next question today comes from the line of Jade Rahmani from <unk>. Please go ahead. Your line is now open.
Thank you very much in terms of the credit trends that we're seeing.
The mortgage rates consistently have been taking an uptick in credit reserves and experiencing you.
You know an increasing number of one off maturity loan defaults, but how would you characterize the overall environment are you seeing sort of a broader.
And widespread downturn in commercial real estate credit do you believe that this is so focused within the fund and mortgage REIT space or do you think banks and life insurance companies as well as CMS are experiencing the same.
It's a good question Jade appreciate I would I'd say first and foremost is the factor that is uniform throughout all types of.
Real estate lending as the precipitous increase in base rates right. I think you know certainly we saw the benefit from lower LIBOR. So for all going back two three years and.
Stress in the system. When you have a 400 basis point increase in rates, obviously hurts from a coverage perspective, but also eventually cap rates as well I think the advantage if I could point to one with respect to the mortgage REIT or private lending space. If you will.
<unk> is the more active asset management that is available to us without.
Some of the sea loads that you might see in the <unk> sector as you work through some of these issues.
And I think the capitalization, obviously it is a bit different but tae sik, let me see it turn it over to you for anything you might want to add as well.
Yeah, Brian just to maybe add to some of your points.
Jade I think what we're seeing is you know.
Borrowers who are most impacted by the movements in interest rates you know.
Are the ones that are being obviously, the most impacted given the dramatic volatility first and the dropping rates and now the sharp increase in rates.
You know, we're also saying maybe a second category of borrowers who have you know.
What we would define as maybe at a little bit more challenging business plans that are harder to execute again in a market, where not just interest rate volatility, but different trends happening.
In terms of for example office utilization.
More supply coming on into certain markets.
So really those are I would say the two general trends or buckets of of challenges. We're seeing you know those that are really impacted directly and I don't say just by changes in interest rates, but primarily by changes in interest rates and then those that have.
A bit more challenged or difficult business plans that are just.
More difficult to execute.
Again in a in a more macro.
Challenged environment.
Thank you very much the risk four and five rated loans I believe those would be considered the watch list and can you talk to the percentage of those that are funded on credit facilities.
And that are funded.
Within Clo's.
And what the liquidity requirements therein would be from Akers.
Acres available capital.
Yeah.
Yeah, it tastes, if you're under or.
Yeah, no absolutely. Thank you Brian .
Jay its a great question and obviously you know when we look through our portfolio. You know as you know we are very very careful about making sure that when we finance an asset that we know that if something goes wrong with that that asset or there's a challenge with that asset that you know that we have the liquidity and the capability too.
The resolve that so one of the things that we mentioned is obviously the amount of liquidity that we have available to us today, you know more than $200 million.
In her opening remarks, and certainly one of the potential uses of that is to potentially deal with any loans that we have in either close or on one.
One of our warehouse lines, so the loans that.
It had been status or satisfies the one loan that we hadn't satisfied.
You know the ones that we have had on for a while you know those are either unlevered in some situations or we are clearly working with the warehouse lender.
And those situations and again, we have the liquidity to handle those situations.
The more recent ones that have had some maturity default issues. The three that we mentioned since year end again, it's a mixture of loans that are either in warehouse lines or in our C. L. O's.
But again, given our liquidity situation as well as the diversification of financing vehicles that we utilize.
No we have two different C. L. OS we have five different line lenders and we make sure that you know that we have diversification by those by those financing vehicles. So we feel you know we're in a pretty good spot to be able to deal with.
The leverage of our senior loans that are risk rated fours at this point.
Yeah, maybe I'll just add one thing jades question, just some specificity around that you can assume roughly half of those risk rated four or five loans or unlevered.
Think that speaks to the approach we've consistently taken as tastes it goes out.
Unlevered, including both the CLO and credit facility.
That's correct.
Thank you very much.
Thanks.
Great.
Yeah.
Thank you. The next question today comes from the line of Rick Shane from Jpmorgan. Please go ahead. Your line is not only thing.
Thanks, everybody for taking my questions.
And hope everybody is well.
So when we look at the K, what you disclosed is that at the end of the fourth quarter, there were $45 million on non accrual.
As you also discussed on this call and in the K, there's an incremental $150 million of maturity.
Maturity defaults at the beginning of this quarter.
I'm curious if that.
That is the 150 is added him to the 45 million of non accruals or is some of the that 150 already on non accrual.
I've tasted alright, great. Thanks for your question.
Yes, Thanks, Brian .
Yeah, I know Rick so the loans that are on non accrual as of 12 31 2022.
Does not include any loans that we mentioned of three loans that went into default in the first quarter.
2023, so we will obviously continue to evaluate those loans, we certainly evaluated them as of 12 31 22.
Obviously, we've now had a subsequent event to that.
So we will evaluate it but to answer your question. So none of the non accrual loans as of 12 31 22 included the three loans that subsequently went into default.
Yeah.
And then not to be too cute here, but.
When I read the accounting policy it doesn't sound like there's any discretion.
On defaulted loans for non accrual, but those unless theres resolution by quarter end, the $150 million will be on non accrual correct.
Yeah.
Yes.
Again, I think we will look at each situation.
Basically we have historically put loans out of some of the loans that are on non accrual have not been in default and we're still paying interest.
And so I think going forward, we will certainly evaluate these three loans that are now in maturity default you know as well as any other loans.
And again there is time between now and ended the quarter to work with each of the situations.
Again, each situation is quite unique.
But we will continue to work with each of the three situations. So I do think it's too early to maybe making a forecast or some sort of estimate of.
The non accrual status potentially of those three loans that already maturity default today.
But again, we will certainly work through very carefully all three situations and make the proper assessment.
First at the end of the first quarter.
Got it okay.
Obviously, there is there are a lot of moving parts there.
Discussion with the account and there's potential resolutions potential visibility to outcome that impacts all that that said if we were to assume.
They were placed on non accrual $150 million, assuming roughly an 8% yield that works out to about $3 million a quarter in contribution from an interest income perspective is that the right way to think about it.
Yeah.
Yeah, I mean, each each loan.
You know I think you can tell on our sheet will have its own you know interest rate, but yeah that sounds roughly about the right calculation.
And again as you mentioned I think we will be.
Scrutinizing and certainly paying a lot of attention to all four rated loans right and certainly those three included in.
And I think you outlined the considerations that we will take into account you know, particularly what we believe is the ultimate outcome of these of these loans.
One thing that Brian mentioned in his opening remarks is that.
Each one of these particularly.
Particularly four rated loans.
It is a very sort of individuals' situation.
A four rating doesn't indicate a loss doesn't indicate non accrual, but it does indicate you know alone that deserves and warrants higher scrutiny and attention.
So I think we should leave it at there at this moment just given that it's sort of mid quarter, but suffice to say that you know these loans are getting very very strong attention from our asset management team very strong attention from our finance and accounting team and we believe we will make the appropriate decision closer to.
Closer to quarter end about you know what is the appropriate classification of these loans going forward.
Fair enough I appreciate the fact that with all of the different.
Interest.
Involved in negotiating with the sell side analysts.
On the rest of the way, we should I would call probably not your intent.
Okay.
Thank you Rick.
Thanks, guys.
Thanks, Greg.
Thank you. The next question today comes from the line of Stephen Laws from Raymond James. Please go ahead. Your line is now open.
Hi, good morning.
Good afternoon.
To follow up quickly on <unk> comment.
Yeah.
How much are we going to is this already reserved for as far as the Q1 events and a general that'll move can be reallocated as a specific reserve in Q1 or do you expect material increases in the reserves.
How should we see that flow through in Q1.
Yeah.
Yeah.
Yes, Jason why don't you get started here if that's all right.
Sure absolutely great question Steven.
I think one thing that is important to recognize is that when we look at our <unk> reserve.
You know close to $50 million of that 70.
1 million balance that we carry at year end is related to four or five level four or five rated loans.
We did we did resolve the five rated loan as we mentioned you know the residential loan out in California that was resolved.
And that it was $5 6 million of the total reserve, but overall at year end, just under $50 million of or about 70% of the reserve.
What was.
It was tied to the four or five rated loans.
It doesn't mean, obviously that that reserve isn't going to change up or down.
But we do believe that certainly.
A strong majority of our reserve is is focused on and is allocated to.
And derived from the four or five year loans.
So there is there is clearly a connection between the risk ratings and the and the reserve amount, but again that doesn't mean, there won't be any change.
In terms of migrating from general too specific.
Thus far in our company's like we've only had one specific reserve, which again was the residential loan in California that was rated a five we carried a specific $5 6 million reserve against that asset obviously once it was resolved.
<unk>.
The realized loss.
It came very very close to the specific reserve amount. So we believe we had thought.
Classify that.
You know appropriately through its life.
Again, I think it's too early.
To really forecast or give you any further insight certainly as of year end 2022.
We do not believe that there was any other basis for specific reserves on any of the four rated loans or otherwise, but again, we will continue to evaluate all of the loans, particularly those that are rated four to see if any migration from four to five from general to specific is warranted, but I still think it's.
Again too early in the quarter to make any general forecast or assessment.
[laughter].
Thanks for those comments Tae sik to touch base on the office exposure you know I know one of the three loans I believe was office other two mixed use of the three loans that went into non accrual.
Q1.
It looks like three of your four largest office loans have a maturity date in Q1 can you talk about those loans are those discussions do you expect repayments or extensions or modifications kind of how do you. How do you expect those I guess its loans.
One two and four and office exposure.
Yeah.
Good question, Stephen I think we're working through and we're in dialogue with those folks I think similar to what we said at the outset theres not much of a data set necessarily to point to with those three loans.
They each have different profiles in terms of where they're at in their business plan.
Some of that normal discussions you'd expect to occur are ongoing.
And I think it'll be.
That dynamic, but things that we're working through at normal course at this point.
Okay, great. Thanks Bryan.
Thank you.
Okay.
Thank you.
Next question today comes from the line of Eric Hagen from BTG. Please go ahead.
Yeah.
Hey, Thanks, Good afternoon, I Hope you guys are well.
And then downgraded loans, where you're saying the same thing.
You noted a deterioration in the business plan can you get more specific on what you're seeing there like how much of an additional funding component is associated with those loans.
And how the weaker business plan in general just kind of effects that the debt yield or the value of the asset in general.
And then how are you guys thinking about hedging interest rate risk from this point forward.
Like what are some of the variables that you're looking at either maybe put on some more hedges or potentially lighten up.
In that department.
Good question I'll start on the.
Business plan and I'm sure the mic with tastes like a little bit with respect to your latter question, Eric but thank you.
Yeah, I think as I said in the opening remarks, right, which is just the Max headwinds in certain.
Certain sectors office obviously.
The point of the spirit to a degree and so what that means is either.
Renovation or value add component of the business plan is taking longer in certain instances throughout our broad industry function of supply chain issues and increased costs associated with those rabbit.
As you know in general our industry would have.
Completion guarantees things like that associated with those business plans, but they are at times, taking longer and I think while the benefit I noted earlier.
Sure so for lower LIBOR for a period of time benefited these capital structures.
Or square the COO.
Cost of carry is simply higher than what some projected by.
Our next underwriting their assets so when you combine that.
That element of stress with that at the capital structure level with with some slower leasing intervals.
That's a that's really what I'm, what I was speaking towards but Tae sik do you want to talk through on the interest rate side, what our thoughts are and some of the impacts that we've seen from but we did proactively a couple of years ago.
Sure no absolutely.
Eric Great question about you know our thoughts on interest rate hedging.
Just a little bit of context in history and I'll just keep it very very brief.
But you know our R. R.
Our thoughts on liability management has always been focus on match funding right. So we have 98% floating rate assets, we want to match that with floating rate liabilities.
And really the reason we did a very very large hedge.
You know about two years ago was not really a forecast, which direction interest rates would move but again consistent with our policy and consistent with our goal of match funding. We have the fortunate situation, where we had significant in the money.
Interest rate floors on our assets such that even though technically they were floating rate loans. They were economically behaving like fixed rate loans.
Because we were so deeply in the money with LIBOR floors that were 150 to 250 basis points when LIBOR was.
10 to 20 basis points. So they were behaving like fixed rate loans and so we felt it very consistent and very appropriate to therefore match fund are now economically behaving fixed rate assets with some fixed rate liabilities.
When we enter into a very large an interest rate hedge.
About $1 3 billion, if I recall about two years ago, and obviously, we were very fortunate to have done that.
Not knowing of course, which directions interest rates would move.
Of that we still have around a third of that about $410 million of notional amount.
Hedges in place today.
In addition, we were I think.
Advantage of.
The interest rate curve.
And when we refinanced our $150 million I'm, sorry about my voice here.
$150 million secured term loan.
We did decide to take that on a fixed rate basis, and we're able to lock in a very low interest rate there as well.
I would say going forward I think we will continue to be guided by our prediction of where interest rates are headed are really our policy of match funding our assets and liabilities and right. Now again, we have a 98% floating rate asset base and so I think we will focus in the future on a floating rate.
Ability base.
Got it that's helpful detail. Thank you guys very much.
Thank you.
Thank you.
As a reminder, if you would like to ask a question. Please press star followed by one on your telephone keypad.
Our next question today is a follow up question from Jade Rahmani from <unk>. Please go ahead. Your line is now open.
Thanks, just a quick quick clarification, I think Rick Shane said, there's 45 million of loans on nonaccrual as of yearend I thought the value was around the carrying value was around $99 million just wanted to check that number.
Jade I think it's a good point.
So we had.
One loan that's $57 million.
A second loan that is $35 million and then the one loan that has been subsequent resolved.
The L. A residential the Los Angeles, California residential asset of about $14 million I think those are the three loans that were on non accrual at year end.
Obviously, the California alone has been resolved, but the other two are remaining.
Okay. Thanks.
Thanks very much.
Yes, I think.
The 45 million was as of year end 2021, and so maybe there was some some thought but it but it is $99 million as of year end 2022.
Thanks.
Yeah.
Thank you.
There are no additional questions waiting at this time, so I'd like to pass the conference, saying that you're behind on a hunt for any closing remarks.
I appreciate it.
Just want to thank everybody for their time today. We appreciate your continued support of Ares commercial real estate and we look forward to speaking to you again on our next earnings call. Thanks, everybody.
This concludes today's conference call. Thank you for your participation you may now disconnect your lines.
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Yeah.
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