Summary
- Ares Commercial Real Estate Corporation is a well-managed REIT, but the stock price has suffered lately.
- Dividend coverage likely remained robust in 3Q-22.
- Ares Commercial is now trading at a 31% discount to book value.
Investors are more concerned about a recession than at any point in the last year, and opportunities abound. Investors interested in generating passive dividend income that is covered by distributable earnings should consider purchasing Ares Commercial Real Estate Corporation ( ACRE ) on the most recent stock price weakness.
The discount to book value has risen steadily and now stands at a whopping 30%. The valuation reflects an extremely high margin of safety, and the dividend yield has risen to 13.1%.
30% Discount To Book Value Wholly Undeserved
What has changed since my last update on the commercial mortgage REIT ACRE is that the sector has taken a significant valuation hit, which I do not believe is justified given that originations remained strong in the second quarter. I believe the valuation of Ares Commercial Real Estate now reflects a very high margin of safety.
ACRE was trading at a 7% discount to book value two months ago when I covered the company, but the discount to book value has now risen to a whopping 30%, indicating that the market has gone a little too far in its pessimism about the commercial real estate sector.
Ares Commercial Real Estate provides investors with access to a well-managed, senior-loan focused debt investment portfolio with a strong focus on offices and multi-family real estate.
The value of the investments was estimated to be $2.6 billion in the previous quarter, and the total loan value is expected to be similar in 3Q-22.
Higher Interest Rates Are A Good Thing For ACRE
The central bank, which delivered its third super-sized 75-basis-point interest rate hike to markets in September, has been a driver of recent stock price weakness. Higher interest rates benefit Ares Commercial Real Estate's senior loans because they are linked to floating interest rates, which means higher interest rates translate into higher net income for ACRE.
A 100-basis-point increase in the benchmark interest rate index results in $0.24 per share per year higher net income, according to the trust's interest sensitivity schedule.
As a result, the trust's pay-out ratio may improve, and the dividend may have an even higher margin of safety if the central bank continues to raise short-term interest rates.
The Dividend Remains Covered
Ares Commercial Real Estate pays its dividend and has a good margin of safety. The trust distributed 92% of its distributable earnings in 2Q-22 and 93% of its earnings in the previous year.
The dividend coverage ratio for the third quarter will most likely be in the low to mid 90% range, similar to what we've seen on a quarterly basis over the last year.
The current base dividend is supplemented by a $0.02 per share per quarter special dividend, for a total dividend pay-out of $0.35 per share per quarter and a dividend yield of 13.1%. ACRE has a yield of 12.4% without the special dividend.
Why ACRE Might See A Higher Valuation
Mortgage originations remained strong in the second quarter, so I'm not sure why Ares Commercial Real Estate's stock was downgraded in September, despite general market concerns.
The company does have a disproportionate exposure to the more volatile and unpredictable office market, which is where I see some risk.
Only a drop in originations, in my opinion, would justify a significant downward adjustment in the trust's valuation.
My Conclusion
Ares Commercial Real Estate appears to be a Strong-Buy opportunity, as the fundamentals in both the commercial real estate market and the trust's portfolio remain strong.
Ares Commercial Real Estate's 13.1% yield is obviously a strong selling point, but what I think makes ACRE more compelling as a dividend play than anything else is that the trust covers its dividend with distributable earnings and that the stock is now trading at an extreme and unjustifiably large 30% discount to book value.
I believe the valuation here reflects a significant margin of safety, and investors may want to consider purchasing the stock for its passive income.
For further details see:
Ares Commercial: I Am Buying This Fat 13.1% Yield