ARCC - My Biggest Stock Purchase For March - ACRE

Summary

• I share my single largest stock purchase to start March off on the right foot.
• Ares Commercial Real Estate has a management team that defines "Get rich or die tryin'."
• You want your investments to be run by a management team with such a laser focus, so you get paid for their effort.

Co-produced with Treading Softly.

Many of my frequent readers are likely still working their regular jobs and setting aside money for retirement in their 401k plans if they are offered ones from their workplace. A subsection of that group also has an IRA account in which they are saving for retirement as well.

For years, I made a monthly contribution to my IRA to increase its balance from the excess income I generated that month. This sum of money was put to work generating new income. This way, along with the countless dollars of dividends pouring into my account, I continually had cash to make additional purchases.

I have said it before, and I'll reiterate it again, I am a net buyer of the market in my portfolio. I have never espoused the idea of going strictly into a cash position to avoid a potential dip or crash. I aim to hold top-notch securities for the long haul and enjoy the income they provide.

So as many of you make plans to add cash to your retirement account, or plan to make your game plan for March, let me share the single largest share purchase I made to get my March started off on the right foot.

Let's dive in!

A Greek God of Income - Yield 12.4%

Ares Commercial Real Estate Corporation ( ACRE ) is a commercial mREIT managed by Ares Management ( ARES ) with a gigantic yield of 12.4%. ACRE reported distributable earnings of $0.44/share, easily covering its $0.35 in Q4 dividends by 125%. ACRE capped off 2022, with distributable earnings climbing every quarter – climbing from $0.35, which barely covered the dividend, up to $0.44. Source .

ACRE did this while leverage declined from 2.5x debt-to-equity to 2.1x.

Book value declined slightly, from $14.39 as of December 31st, 2021, to $13.73 as of December 31st, 2022. This decline in book value was primarily due to higher CECL (current expected credit loss) allowances of $0.88/share.

In other words, ACRE saw higher earnings, using lower leverage and stable book value in 2022. Meanwhile, the outlook for earnings is a continued upward trend as ACRE directly benefits from rising interest rates.

So why isn't the market thrilled?

The most likely answer is that the market sees a rising risk of defaults. In fact, ACRE disclosed on the Q4 earnings call that there were three "maturity defaults" in their portfolio. CFO Yoon stated:

Since year-end 2022 driven by some of the broader market dynamics that Bryan mentioned earlier, three additional senior loans experienced maturity defaults including two loans backed by mixed-use properties and one loan collateralized by an office property. While we have different paths to 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."

It is a reality of lending that not all borrowers will be able to pay as agreed. The part science and part art of lending is in setting interest rates high enough to account for default risk. So that even with some number of defaults, the lender is making a profit. The higher the risk, the higher the interest rate that is needed.

It simply is not realistic to expect that every company that borrows money will pay it back on time. What we need to do is quantify the risk. In commercial real estate, a default rarely leads to a 100% loss. The reason is that the property has value, and most of ACRE's loans are "senior" mortgages. This means they have the right to foreclose on the property and take possession of it or first dibs on any proceeds from the sale of the property.

In fact, management announced in the earnings call that a previously defaulted residential mortgage in Los Angeles was restructured for a 98% recovery of principal. Also, in 2022, ACRE sold a hotel property for $38 million that had defaulted in 2019. The end result was a gain on their original investment, despite COVID significantly disrupting the hotel industry in 2020.

This is where the relation to ARES is invaluable. ARES has the resources to bring in private equity, provide numerous debt solutions, and some of the world's foremost experts on restructurings. We've seen with Ares Capital ( ARCC ) how Ares can frequently turn a default into a situation to gain even larger future profits. ACRE isn't a bank that necessarily takes a property and auctions it for pennies on the dollar. They have the capabilities to take over and operate properties until conditions are right to sell, like they did from 2019 to 2022 with that hotel.

The current method to estimate future losses is "CECL" or "current expected credit loss." In the old days of the Great Financial Crisis, lenders like ACRE were not allowed to write down projected losses. They were forced to be looking in the rear-view mirror and assume that future losses would be consistent with past losses. In the wake of the GFC, CECL became the new accounting standard. It seeks to be more proactive at estimating expected lifetime credit losses of the existing portfolio. Source .

Since CECL requires companies to update their models as conditions change, rising interest rates and projections of a potential recession have caused an increase in CECL reserves.

Increased or decreased CECL reserves are recognized on the income statement and carried on the balance sheet where investment values are reported net of CECL reserves. There is a "general CECL reserve," which is applied to all assets and there can be asset-specific CECL reserve which is added when data suggests a specific asset might experience a credit loss.

ACRE's current book value of $13.73 represents an expected credit loss of 3% across its entire portfolio. For a historical perspective, commercial real estate loans' experienced delinquencies peaked at around 4% in 2010, and realized losses peaked at 1.2%. Cumulative losses were 3.75% for the entire GFC.

In other words, at 3% reserves, ACRE isn't quite pricing in another Great Financial Crisis, but it isn't as far off as you might think. The current CECL reserves are currently pricing in turbulence that isn't quite as bad as the GFC but is worse than the Dot-com bust. With the common shares trading at a 15% discount to book value, ACRE would have to realize losses of 7.8% for book value to fall to the current market price. That would be a loss rate twice as severe as the GFC.

The reality is that we don't know how effective CECL will be at accurately projecting losses. What we do know is that it is more proactive and, therefore, more conservative than historical methods.

Yes, there will be defaults. Yet when it comes to the hustle, ACRE's management is one of the best in the business at maximizing recovery. That's why ARCC is one of our favorite BDCs, and we are happy to buy ACRE while it is trading at a substantial discount.

Conclusion

With ACRE, I can invest my money into a management team that defines the concept of "hustle" and enjoy the income that their effort produces. ACRE goes Ex-div on 3/30 with a generous $0.35 per share dividend to be paid in April. So you can load up this month, and ACRE will immediately start rewarding you in April to help you buy new picks for that month.

ACRE is one of those investments which will pay you to keep on holding them in the good times and the bad - exactly what a retiree wants for their retirement portfolio.

That way, you can spend the rest of March planning out your April purchases or making smaller fine-tuning adjustment purchases. This frees you up to enjoy all that March has to offer you to explore and enjoy before April showers come raining from the sky.

Personally, I'll be enjoying the outdoors with my family and dogs. The weather looks to be perfect to do just that.

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