STWD - 14%-Yielding Ares Commercial Real Estate: The Market Is Way Too Pessimistic

2023-08-23 09:00:00 ET

Summary

• Ares Commercial Real Estate stock price has fallen by 27% in the past year due to company-specific and macroeconomic concerns.
• Its portfolio is made up of 98% senior loans and the stock currently trades at a substantial discount to book value.
• Despite concerns about exposure to office loans, ACRE has stable non-accrual levels and a strong balance sheet, offering appealing value with a dividend yield of 13.7%.

Real estate has been a tricky space to navigate over the past 12 months, as vacancy rates, interest rates, and macroeconomic concerns have weighed heavily on the sector. Such has been the case with Ares Commercial Real Estate (ACRE), whose stock price is down by 27% over the past 52 weeks.

I last covered ACRE here back in February, at which time the stock already seemed like a good deal, and the stock price has slid by 17% since then, due in part to the regional banking crisis in March and investor wariness over commercial real estate. In this article, I discuss why ACRE currently presents a decent high yield option at the current price, so let's dive in!

Why ACRE?

Ares Commercial Real Estate is a commercial mortgage REIT that's managed by Ares Management (ARES), one of the leading players in the alternative asset management space. Its loan portfolio carries a $2.3 billion value that's spread across 53 loans and is comprised of 98% senior loans.

One of the concerns that the market may have around ACRE is its higher exposure to office loans than peers Blackstone Mortgage (BXMT), Starwood Property Trust (STWD), and Ladder Capital (LADR). This is reflected by 38% of ACRE's loan portfolio being comprised of office properties, with its next 3 biggest segments, multifamily, mixed use, and industrial properties making up 44%, as shown below.

The market appears to have discounted names with higher exposure to office. As shown below, ACRE stock has underperformed that of its peers except for BXMT over the past 12 months.

An area of concern for investors is the decline in book value per share for ACRE, from around the $14-level to $12.77. This was a result of an increase in CECL reserve, and without that, the book value per share would by $14.84. It's worth noting that simply increasing the CECL reserve doesn't mean that those loans will be a total loss. For example, of the two loans that are in default, ACRE expects a full recovery of principal after the borrower sells the property, and expects to take possession of the other one (a mixed use property in Florida) as a real estate asset.

Moreover, ACRE's non-accrual levels were stable during the second quarter, with 96% contractual interest collection. Also, three-quarters of its loan portfolio (74%) carries a risk rating of 3 or better (on a scale from 1 to 5, with 1 being the lowest risk).

It also has the backing of a strong balance sheet with a net debt to equity ratio of 1.9x, sitting below the 2.4x of STWD and 3.4x of BXMT, and carries $217 million of available capital. Importantly, ACRE continues to cover its $0.33 quarterly dividend rate with $0.35 in distributable EPS during the last reported quarter. As shown below, ACRE has out-earned its dividend on a cumulative basis since 2017, leaving funds as a buffer for CECL, special dividends, and reinvestment.

Risks to ACRE include potential for a prolonged economic downturn, which would create headwinds for borrowers. Also, while office vacancies have declined since the start of the year with many companies requiring their employees to return to the office, there is still plenty of room for improvement on this front.

Considering all the above, ACRE offers appealing value at the current price of $9.64 with a price to book value of 0.75x. It appears that the market is too pessimistic around the stock, considering that the book value already bakes in the CECL reserve.

Management apparently thinks that shares are cheap too, as the company bought back 1.0% of outstanding shares during Q2 at an average price of $8.58, representing a substantial discount to book value. As shown below, the current price-to-book sits at the low end of its trading range over the past 5 years outside of the early 2020 timeframe.

Investor Takeaway

Ares Commercial Real Estate currently offers a juicy dividend yield of 13.7%, which is covered by distributable EPS and with funds left over for reinvestment and special dividends. While its loan portfolio has seen headwinds, the senior nature of its loans gives it a level of protection and options for management to work through a resolution.

Meanwhile, the balance sheet is in good shape with plenty of liquidity available to take advantage of opportunities. Risks are elevated in the current environment, but with the stock trading at a material discount to book value (which bakes in the CECL reserve), enterprising value investors may find this high-yielding stock to be appealing.

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