2023-11-14 15:59:52 ET
Summary
- Commercial real estate industry is facing macro headwinds with falling prices, elevated rates, and increasing delinquency rates for CRE bank loans.
- Ares Commercial Real Estate Corporation maintains resilience with stable credit performance and a well-managed portfolio.
- ACRE offers a double-digit dividend yield and is trading at a 25% discount to book value, making it an attractive investment for optimistic investors.
Introduction
It's time to talk about a fascinating company, the Ares Commercial Real Estate Corporation ( ACRE ) . On August 24, I wrote an article titled Ares Commercial Real Estate: Yielding 13% With Significant Risks .
In that article, I did two things.
- I explained what makes ACRE such a powerful investment for investors seeking commercial real estate ("CRE") lending income.
- I highlighted macroeconomic headwinds that kept me from investing in this company despite its qualities.
In this article, I'll do the same.
However, I won't just repeat what I said back then but use new CRE developments to explain what is happening in the industry. Moreover, we get to discuss the company's quarterly results from earlier this month.
The fact is that clouds are getting darker. It has caused ACRE shares to remain subdued in recent months.
Nonetheless, its earnings were stellar, indicating that while capital gains may be limited, investors are not at risk of suffering from a low-quality debt portfolio.
With all of this in mind, let's dive into the details as we establish the risk/reward of buying this 14%-yielder at a valuation discount.
Macro Headwinds Are Worsening
Commercial real estate was almost a no-brainer trade between the Great Financial Crisis and the pandemic. Rates were low, as was inflation. Meanwhile, economic growth was strong. Banks were eager to lend, and property prices were in a consistent uptrend.
That has ended.
CRE prices are falling, inflation is elevated, and the Fed is unlikely to cut rates anytime soon.
The other day, Globest reported a decade-high in delinquency rates for banks engaging in CRE debt (emphasis added).
Delinquency rates for CRE bank loans are hitting levels unseen for the last 10 years.
“The volume of past-due loans in which owners of properties rented to others have missed more than one payment jumped 30 per cent, or $4bn, to $17.7bn in the three months to the end of September , according to industry tracker BankRegData,” the Financial Times reported.
“The figure had risen by $10bn in a year .”
This does not indicate an immediate crisis as bank lending “remains in historically good shape and even after the recent jump, just 1.5 per cent of commercial property loans were past due ,” the Financial Times noted.
Having that said, the trend is the problem, not the current state of CRE. With 1.5% being past due, we're far from a Great Financial Crisis scenario.
But then again, the trend is what the market uses to assess the risk/reward of investments.
On November 13, the Wall Street Journal wrote an article on emerging troubles in the industry.
Wall Street Journal
The Wall Street Journal analysis reveals a record number of foreclosure notices for high-risk property loans, particularly mezzanine loans, akin to second mortgages. These loans are the first ones to give in when things get tricky.
This year witnessed a notable surge in foreclosure notices for mezzanine loans and other high-risk loans, more than doubling the previous year's total.
The increasing defaults on mezzanine loans provide a more immediate measure of distress in commercial real estate compared to traditional mortgage foreclosure rates.
Unlike traditional mortgages, foreclosing on mezzanine loans is quicker and simpler, contributing to the surge in announcements.
These loans became prevalent in the aftermath of the 2008 financial crisis as property owners sought alternative financing from smaller banks and nonbank lenders.
Wall Street Journal
The current surge in defaults is attributed to rising interest rates, making it harder to refinance mezzanine loans.
Before the rate increases, these loans typically carried interest rates around 10-12%, but now they often exceed 15%, leading to more defaults and foreclosures.
Similar to pre-2008 practices, recent years saw a resurgence in layering mezzanine loans, sometimes exceeding the building's value. This risky approach, coupled with the complex nature of mezzanine loans, is contributing to the current wave of foreclosures.
In general, unless rates come down, we could see a wave in defaults, as displayed by a Deutsche Bank chart.
Deutsche Bank
This brings me to ACRE.
Resilience In Tough Times
Ares Commercial Real Estate has a portfolio of 49 loans covering a volume of $2.2 billion. 39% of its exposure is in the office sector, followed by multifamily.
Although multifamily is a very strong market due to anti-cyclical demand, it's currently suffering from new supply.
Even worse, due to its massive popularity, close to a trillion in debt in this segment will be due.
Outstanding multifamily mortgages more than doubled over the past decade to about $2 trillion, according to the Mortgage Bankers Association. That is nearly twice the amount of office debt, according to Trepp. The data provider adds that $980.7 billion in multifamily debt is set to come due between 2023 and 2027.
That said, ACRE isn't stupid. I believe it is one of the best-managed CRE lenders in the world.
Its total return of the past ten years is close to 90%, making it one of the best income vehicles with a yield exceeding 10%.
During its 3Q23 earnings call, the company noted general stability in credit performance, with a decline in defaults and risk-rated 4 and 5 loans, which is not what one would have expected, given the bigger macro trend.
According to the company, the current interest rate environment has enhanced net interest income but introduces economic uncertainty and challenges to commercial real estate values.
This is what I've said for the past few quarters: higher interest income is great, but elevated financial risks need to be incorporated in any thesis.
The company's lower portfolio risk is certainly one aspect that sets it apart.
Going back to the risk ratings, in the third quarter, credit quality metrics showed improvement, with 78% of the loan portfolio having a risk rating of 3 or better, up from 74% in the second quarter.
The improvement was attributed to the reduction of risk-rated 4 and 5 loans due to resolutions or conversions to REO . No new loans originated in the risk rating 3 to 4 or 5 range during the quarter.
- The CECL reserve increased by a net of $3.2 million in the third quarter, reaching a total of $116 million or about 5.25% of the outstanding principal balance.
- Specific reserves of $55 million were allocated to risk-rated 5 loans, with the remaining reserve distributed among risk-rated 4 loans and loans rated 3 or better.
- The total reserve impacted the book value per common share, which stood at $12.62 as of September 30, 2023.
Ares Commercial Real Estate Corporation
Furthermore, despite market challenges, ACRE believes the CECL reserve appropriately considers current market conditions and the macroeconomic outlook for loans held for investment.
As a result, they continue to engage in opportunistic investments in the market.
For example, the focus is on financing strong property classes with secular demand drivers, including a $58 million senior loan for a Class A multifamily property in Cincinnati, Ohio.
Ares Commercial Real Estate Corporation
Looking forward, ACRE aims to further reduce exposure to office loans by targeting over $70 million in outstanding principal balance clearance in the fourth quarter, extending into the first quarter of the next year.
It also helps that ACRE has a healthy balance sheet, which is helping to sustain its juicy dividend.
In the third quarter, ACRE maintained significant liquidity with a moderate net debt-to-equity ratio of 2.0x.
The company held over $130 million in cash and available amounts under its working capital facility.
Ares Commercial Real Estate Corporation
With regard to the dividend, in the third quarter, ACRE reported GAAP net income of $9.2 million or $0.17 per common share. This number was influenced by the aforementioned $3.2 million net increase in the CECL provision, equivalent to $0.06 per common share.
Distributable earnings for the same period were $13.5 million or $0.25 per common share, impacted by a $4.9 million or $0.09 per common share realized loss on a defaulted hospitality loan resolved during the quarter.
The company announced a $0.33 per-share dividend.
Ares Commercial Real Estate Corporation
This $0.33 per share per quarter dividend translates to a yield of 13.9% yield.
Given that distributable earnings are slightly below the dividend, I believe we're now at the limit of dividend growth, as I cannot imagine that a further potential surge in rates could prevent credit losses from accelerating.
While it's hard to estimate the sweet spot between rates and financial stability, I believe we're past the sweet spot, where interest rate risks outweigh the benefits.
This is what the company said when it was asked about the sustainability of its dividend during its earnings call (emphasis added):
Jade Rahmani
Thank you very much. For me, one of the important pieces is cash flow from operations, and it's been running a little bit below the dividend . So what would be your thoughts as to dividend sustainability at this point?
Tae-Sik Yoon
[...] So if you look at third quarter 2023, for example, I think our net cash provided by operating activities is around $13.5 million. And we think in addition to that $13.5 million, you would add, for example, $1.5 million of fees that we have already received, for example, as origination fees upfront, but we don't amortize it under the cash flow statement, obviously, because it's cash flow. But that is actual cash that we have already received as part of making a loan. And again, that adds about $1.5 million. So you're up to about $15 million from there.
And then the second thing just to -- again, to point out is if you kind of look at our dividends for the third quarter, I think what you'll see is in cash flow, again, you'll see that dividends paid in the third quarter was really the dividends declared for the second quarter, which included the $0.02 supplemental, which obviously was not declared and payable for the third quarter dividend . So I think the difference that you might be seeing is a little bit smaller than maybe where you started out with.
But we do think that our distributable earnings is a very good measure of our actual cash flow . I think probably the biggest difference you'll see between those two measures, again, taking into account some of the timing differences of when you pay payables, receive receivables, there's probably some payment-in-kind loans. We think we have a fairly limited amount of that, but that would probably be the biggest difference between actual operating cash flow versus our distributable earnings .
So, what about the valuation?
Valuation
ACRE, which usually trades close to 90% of its book value, is trading at a 25% discount compared to its book value.
This could mean two things (and I hate to be this vague):
- Investors expect the company to run into more trouble as the macro trend is in the wrong direction.
- The stock is extremely attractive to investors who believe the economy won't get much worse.
As much as I like ACRE and its ability to make the best out of an increasingly tricky situation, I cannot get myself to recommend commercial real estate debt - regardless of a juicy dividend and attractive valuation.
I need to see more damage in the industry and a clear sign that the Fed may be easing. Once that happens, I'll likely throw some money at ACRE in income-focused portfolios that I manage/advise.
Nonetheless, if you disagree with me on the economy (which is fine), I think ACRE may be right for you.
Takeaway
While general macroeconomic trends, rising interest rates, and increasing defaults on mezzanine loans signal industry troubles, ACRE maintains resilience.
With a well-managed portfolio and a focus on reducing exposure to office loans, the company sustains stability.
Despite market challenges, ACRE's healthy balance sheet supports a double-digit dividend yield.
The current 25% discount to book value reflects investor uncertainty.
Whether ACRE is a viable investment depends on your economic outlook.
Cautious investors may await clearer industry signals and potential Fed easing, while those optimistic about the economy may find ACRE's attractive valuation and dividend appealing.
Personally, I believe ACRE is beyond the "sweet spot," where financial risks outweigh the benefits of elevated rates.
For further details see:
14%-Yielding Ares Commercial Real Estate: We're Beyond The Sweet Spot