ACR - ACRES Commercial Realty: Leveraged On High-Risk Loans Not An Opportunity

2023-03-10 09:42:24 ET

Summary

• ACR invests in the riskiest type of real estate loans, variable-rate commercial real estate.
• The company leverages those investments through VIEs but also takes on debt at the corporate level.
• Although credit quality has not been fundamentally impaired, the risk of the loans was high, to begin with, and already shows some signs of deterioration.
• With so much leverage, even minor credit quality issues could significantly affect the company's book value.
• For that reason, I believe ACR is not an opportunity at these prices.

Acres Commercial Realty Corp. (ACR) is a commercial real estate lender REIT. The company's book fully comprises commercial real estate held through heavily leveraged securitization vehicles.

ACR trades at a deep book value discount, with a P/B ratio of 0.2x. This discount exists because the company operates in the riskiest real estate lending segment (commercial real estate) and carries enormous leverage.

Similarly, ACR trades at a low P/E ratio of 3x, but this ratio does not account for millions in preferred share dividends. The company generates much smaller income attributable to common shareholders when preferred dividends are accounted for.

The current discount on ACR's book value is justified by its enormous risk. A simple analysis of its loan book quality reveals that the company's equity could be severely impaired. Further, its board of directors has not shown an ability to manage risk, with the company writing almost $200 million in losses in 2020. Going further, ACR lost 92% of its value in the GFC.

I believe ACR's common stock is not an opportunity for these reasons.

Note: Unless otherwise stated, all information has been obtained from ACR's filings with the SEC .

Business description

Leveraged commercial real estate : ACR's balance sheet is 88% comprised of commercial real estate ((CRE)) loans held through consolidated securitization vehicles called variable interest entities (VIEs). There are two risky portions of that name: CRE and VIEs.

CRE is considered the riskiest type of real estate loan. The reason is that repayment capacity is tied to collateral, and collateral value is tied to repayment capacity.

If ACR lends to a developer that purchases a hotel, that developer can only repay if the hotel is profitable. It has no other income sources from which to cover repayment. Further, if the hotel is not doing well, the property's value (the collateral) is probably impaired.

VIEs are separate entities on which ACR holds the equity portion. After creation, the VIEs issue debt with different seniority tranches and use that debt to purchase ACR's loans. The accounting rules issued after the dot-com and GFC crises indicate that VIEs must be consolidated for the equity holder.

These vehicles are leveraged 5x, meaning they have five times more assets than equity. Further, the senior holders are prevented by over-collateralization clauses, and if the collateralization is breached, a default ensues.

For that reason, when collateral is impaired (for example, when the loans are impaired), ACR may need to purchase the loan or the foreclosed property from the VIE at their amortized value for the VIE to repay a portion of its debts and prevent the collateralization levels from falling below default triggering levels.

ACR non VIE debt : ACR also carries debt taken at the corporate level, which finances the equity portions of its VIEs. The company also uses these funds to purchase loans from the VIEs when impaired and can threaten over-collateralization clauses.

Specifically, the company records $1.9 billion in borrowings, but only $1.2 billion are consolidated from its VIEs. The remaining $700 million exist at the corporate level. This is used to finance, $600 million in CRE loans not carried at the VIE level, $200 million of repossessed properties and $300 million in the equity portion of the VIEs.

No interest rate mismatch : ACR's assets and liabilities are tied to variable interest rates. This avoids the risk of the company's debt costs rising faster than the company's interest income.

The company's loan assets are tied to one-month SOFR and LIBOR plus a benchmark. As of 3Q22, the company's loans were generating a yield of 6.5%, against SOFR and LIBOR rates of 2.5% on average, which implies an average premium of 4% over the benchmark.

Conversely, the company's variable rate debts ($1.6 billion) paid an average benchmark of 2.5%. Further, the company has another $250 million paying a fixed 5.75%.

Maturity is not a short-term risk : The company's securitization vehicles have debt instruments maturing in over ten years. Maturity is not a short-term risk for them.

On the other hand, the company financed part of the debt carried at the corporate level with approximately $378 million in term warehouse financing facilities maturing in 2024. These could become problematic, and refinancing will depend on credit conditions at that time.

High managerial compensation: ACR does not manage its investments but has a management agreement with an affiliated party. The managerial agreement provides a minimum payment of 1.5% of book value to the managers, irrespective of performance, with a minimum of $5.3 million yearly. Further, if the company's ROE exceeds 1.75%, 20% of the excess is paid to managers as a performance fee. I think this arrangement provides too much compensation because it guarantees a substantial base payment and the performance hurdle rate is low.

Valuation

Loan book quality : ACR's key question is whether its loan book can withstand the recent hike in interest rates with sufficiently low defaults so that the company's equity is not wiped out.

Starting with real estate assets that come from repossessed properties. These accounts grew by $110 million in the first nine months of 2022, from $89 million in December 2021 to the current $200 million. These are foreclosures transferred from loan assets.

Continuing with repurchased loans, the company's complete loan book value grew by $230 million during the 9M22 period. However, the company's VIEs' assets decreased by $368 million. This indicates that the company purchased loans from its VIEs. The equity on the company's VIEs fell from $400 million in December 2021 to $265 million in September 2022.

When self-developed risk ratings are considered, $300 million in loans were not performing as expected during underwriting in 3Q22. From these, $30 million were past due. ACR had to renegotiate six loans during 9M22. In the earnings release of the 4Q22 results , the company posted $10 million in higher provisions for credit losses.

Finally, another sign of distress is the accrued interest receivable account growth. The equity and the low-class portion of the debt that ACR holds on its VIEs can defer interest income without triggering an event of default . The account for accrued interest grew from $6 million in December 2021 to $12 million in December 2022.

This indicates that ACR's loans were not doing great in 2022 but that the company has not recognized losses because it has moved them from the VIEs to its balance sheet and from loan assets to investment properties.

Risk management history : The picture is not great if we look back at ACR's risk management history.

In 2020 , the company recognized $185 million in losses from non-qualifying mortgage-backed securities financed with repo loans that were margin called during the March COVID crisis.

The company had invested $500 million in commercial mortgage-backed securities and had leveraged that investment through repurchase agreements. When the COVID crisis temporarily collapsed the MBS prices, ACR was margin called, and had to sell the securities at a realized loss. ACR's stock price lost 80% of its value between February and July 2020.

If we go back to the Great Financial Crisis, the company recognized securities and loan losses of $280 million between 2007 and 2010, more than the company's equity in 2007. The company recapitalized in 2010, by diluting its shareholders by 2x. Again, during this period, shareholders lost 80% of their money in the company.

The people at the helm of the company are substantially the same today. According to the 2007 proxy statement, over half of the current board was already part of the company, and after the 2020 debacle, no board member resigned. Although resigning after a 90% share price collapse and writing down $180 million in investments is not mandatory, the fact that the same board is in charge increases the chances that the same mistakes will be make.

Income-based valuation: ACR currently generates losses for its common shareholders. According to the company's recent earnings release, it will post $9 million in losses to common shareholders in FY22.

In historical terms, the company has generated $10 million in net income before payments of dividends to preferred. When those dividends are accounted for, the result is a negative average income to common shareholders for at least the past ten years. The result of this negative trend is more clearly seen at the book value per share level (again, without removing the redeeming value of preferred).

Is the discount enough? : ACR's book value as of 4Q22 is $440 million, but the company's redeeming value of preferred stock accounts for $235 million, leaving $205 million to common shareholders.

With the company trading at a market cap of $85 million, this implies a discount to the book value of 60% or a P/B ratio of 0.4x (after removing preferred).

I think this discount is not enough because the company invests in the riskiest type of real estate loan (variable-rate, commercial real estate), using a significant amount of leverage.

The company's assets behind its CLOs are almost toxic, with Moody's weighted risk factor of 5,000 , approximately equivalent to Caa2 , three notches above default. Morningstar valued the assets as having high default risk in April 2021 before rates skyrocketed. And ACR has the first loss portion of these vehicles.

The rest of the company's book is not much more solid either, also tied to CRE, and also financed with debt.

Conclusions

ACR offers a significant discount to book value for a reason.

The reason is that the company has leveraged on the riskiest type of real estate loan and has a history of mismanaging risk.

Small levels of defaults could make a significant dent in the company's equity, erasing the margin of safety provided by the current discount on book value. There are several indications of asset quality deterioration.

Therefore, I believe ACR is not an opportunity at these prices and in this context.

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