STWD - Ares Commercial Real Estate: Dividend Cut Potentially Incoming In 2024 (Rating Downgrade)

2024-01-02 22:59:52 ET

Summary

• Ares Commercial Real Estate Corporation has been a core holding in my passive income portfolio for the past two years.
• The recent negative change in the company's dividend pay-out ratio is a warning sign for passive income investors.
• The risks have increased to the point where a dividend cut in 2024 is not unlikely, and it may be a good time to sell the stock.

Ares Commercial Real Estate Corporation ( ACRE ) has been a core holding of mine in my passive income portfolio in the last two years.

With that being said, though, I think that the most recent, negative change in the real estate investment trust’s dividend pay-out ratio is a warning sign for passive income investors.

Risks, in my view, have increased to such an extent that a dividend cut in 2024 is not entirely improbable and with the stock selling at a much smaller discount to net asset value than earlier last year, this might be a good time to sell.

As part of my portfolio review process at the end of 2023, I decided to sell my stock in Ares Commercial Real Estate.

My Rating History

Ares Commercial Real Estate started to see a deterioration of fundamentals in the first quarter of 2023, but the trend has not gotten better lately. Due to a smaller discount to book value and a reduced margin of dividend safety, I modified my stock classification to Hold in September.

Last week, I went through my year-end portfolio review process and sold certain stocks, mostly for tax loss harvesting purposes. Among those stocks that I sold, though not being one of my losers in 2023, was Ares Commercial Real Estate due to growing risks to the dividend.

Dividend Cut Potentially Income For Ares Commercial Real Estate In 2024

Ares Commercial Real Estate is a commercial real estate debt investor. The commercial real estate investment trust primarily invests in senior mortgage loans that are backed by commercial properties.

At the end of the third quarter, Ares Commercial Real Estate was invested in 49 loans worth $2.2 billion, but the portfolio has shrunk most recently, which was in part due to the sale of some troubled senior loans. The portfolio is still predominantly invested in offices and multi-family real estate, which comes with its own unique set of risks.

The large exposure to the office sector in particular has probably been the main reason why Ares Commercial Real Estate’s stock, despite a strong re-rating in 2023, did not manage to move up to book value last year.

The headwinds in the office real estate sector have been well-documented, and you can read here why office real estate has faced considerable pain in 2023.

These headwinds have been the reason why Ares Commercial Real Estate was forced to sell some senior loans at a loss in 2023 and why it increased its current expected credit loss reserve. The majority of this CECL reserve (72%), not surprisingly, related to the trust’s large office loan portfolio.

The trend in Ares Commercial Real Estate’s dividend pay-out ratio is concerning, for obvious reasons. As you can clearly evaluate in the pay-out ratio trend displayed below, the trust’s pay-out ratio has reached a level that I would judge to be unsustainable.

Ares Commercial Real Estate’s pay-out ratio has seen a rather concerning rise as the trust paid out 105% of its distributable earnings in the last year. The pay-out ratio in the first and third quarter of 2023 exploded higher, primarily due to the trust realizing losses from the sale of troubled senior loans: The trust’s distributable earnings got set back by $0.10 per share in 1Q-23 and $0.09 per share in 3Q-23 due to ACRE realizing losses on loan sales. The pay-out ratio in 3Q-23 was a whopping 132% which indisputably reflects high risks of a dividend cut in 2024.

Probably Selling At Fair Value

Ares Commercial Real Estate sold at a large discount to book value in 2023, but this discount narrowed in the second half of the year. The trust also paid a number of $0.02 per share per quarter supplemental dividends, despite being forced to sell some loans at a loss, and it increased its CECL reserve again in the third quarter (ACRE increased its loan loss reserve by $3.2 million in 3Q-23 to $115.7 million).

Ares Commercial Real Estate’s stock is presently selling for a 0.81x book value, which reflects the highest discount to book value when plotted against Starwood Property Trust Inc. ( STWD ) , Blackstone Mortgage Trust Inc. ( BXMT ) and Ladder Capital Corp. ( LADR ) .

I would argue that it is Ares Commercial Real Estate exposure to the office market that is the reason for the larger-than-average discount to book value.

Why I Might Be Wrong

Ares Commercial Real Estate might avoid a dividend cut if the situation in the commercial real estate market improves, meaning interest rates are going to normalize and new defaulted loan sales that depress distributable earnings won’t happen in 2024. In this particular scenario, I could see a restoration of Ares Commercial Real Estate’s dividend pay-out ratio.

At this point in time, however, I am simply not prepared to deal with excessive dividend risks in my portfolio and for purposes of safeguarding my capital, I sold Ares Commercial Real Estate at the end of 2023 at a small profit.

My Conclusion

I think the headwinds for Ares Commercial Real Estate have undoubtedly increased in 2023, and I don’t see how the trend in the pay-out ratio is going to substantially change in the short-term.

With short-term interest rates still remaining above the long-term average, further loan defaults are probable and could further weaken the trust’s pay-out statistics.

Thus, my year-end 2023 portfolio review exercise has led me to sell Ares Commercial Real Estate’s stock as the risk of a dividend cut has undoubtedly risen.

Ares Commercial Real Estate’s 12.7% yield, at least for me right now, is not worth considering, and I am changing my stock classification for the commercial real estate investment trust to Sell.

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