2023-05-16 05:43:26 ET
Summary
- ACRE originates and holds loans against commercial real estate.
- CRE is the epicenter of current market risks, as many borrowers are struggling with higher interest costs due to the Fed's interest rate hikes.
- While ACRE holds 4.0% of gross loans as CECLs, losses in offices could swamp this figure as ACRE had to take a $38 million provision on a $57 million loan.
- Overall, I remain cautious on ACRE stock as I believe the worst is yet to come for commercial real estate.
A few weeks ago, I wrote a cautious article on Ares Commercial Real Estate ( ACRE ), arguing that ACRE's financial performance may worsen in the coming quarters due to worsening commercial real estate fundamentals.
Since my article, the company recently released its Q1/2023 earnings, reporting weak earnings relative to analyst estimates. After reviewing the company's earnings report and conference call, have I changed my cautious view on ACRE?
Weak Q1 As Credit Concerns Materialize
With regards to the first quarter earnings, ACRE reported distributable earnings of $0.27 / share, missing analyst estimates for $0.30 / share. Investors should note that the company's distributable earnings measure is non-GAAP, as it excludes provisions for current expected credit losses ("CECL"). Including provisions for credit losses, GAAP earnings was actually a loss of $0.12 / share, a notable continuation of weakening trend that saw Q3/2022 and Q4/2022 earnings come in at $0.01 and $0.05 respectively (Figure 1).
Figure 1 - GAAP earnings continued to decline (ACRE investor presentation)
Looking at distributable earnings specifically, management blamed the sharp QoQ decline from $0.44/share to $0.27/share on $5.6 million in realized losses on the sale of a residential senior loan that was consistent with specific CECL reserves held against that loan.
Management's commentary raises an interesting question: if a specific CECL reserve was already booked against that loan in Q4/2022, why are we discussing its impact to distributable earnings in Q1/2023? Asked another way, is it correct to adjust GAAP earnings by provisions for CECL to calculate 'distributable earnings', if in subsequent quarters, the realization of prior period CECLs will reduce 'distributable earnings'?
With loan repayments, sales, and net provision for CECLs, ACRE currently holds provisions for CECLs worth 4.0% of its gross loans outstanding, up from 2.9% in Q4/2022 (Figure 2).
Figure 2 - ACRE increased its reserves against its loan book (ACRE investor presentation)
Is 4% CECL Enough?
Historically, if we look at data provided by the St. Louis Fed, charge offs of commercial real estate loans by U.S. banks peaked at around 3% in both 1992 and 2010 (Figure 3).
Figure 3 - CRE loan charge offs for U.S. commercial banks (St. Louis Fed)
So management's claim that ACRE's " CECL reserve levels, properly takes into account current market conditions and future - macro economic outlook, " does have some merit.
However, as I mentioned in my prior article, " CRE loan losses are hard to generalize as each property is unique and loan losses can vary. " For example, in the latest quarter, ACRE held $44 million in specific loss reserves against 2 loans in Chicago: " $5.6 million reserve on a $35 million senior loan, backed by a hospitality property in Chicago metro area, and a $38.3 million reserve on a $56.9 million senior loan backed by an office property, also located in the Chicago metro area. "
So on one $35 million loan, ACRE booked a reserve of $5.6 million or 16%, while on another $56.9 million loan, ACRE booked a reserve of 67%!
Management explained the difference in loss provisioning as due to one property having significant land with redevelopment potential whereas the other property did not. The challenge for analysts and investors is that unless we are local real estate experts, we really have no way of knowing how well the company is reserved for each loan in its loan portfolio before something goes wrong.
Aside from $44 million in specific provisions, ACRE also commented it had $48 million of reserves with " $30 million accrued against $404 million in outstanding principal balance of risk rated four loans, which equates to approximately 7.4% of the total risk rated four loan balance. The final $18[sic] million of our total reserves is held against the 1.7 billion of loans, rated three or better for an average reserve ratio of about 1.1%. "
If economic conditions worsen and more loans fall into the risk 4 category, we may see ACRE have to increase provisions even further in the coming quarters. In particular, ACRE has $823 million in carrying value of office loans or approximately 37.5% of the portfolio that are worrisome (Figure 4).
Figure 4 - ACRE has $823 million in office loans (ACRE investor presentation)
However, outside of the $38.3 million in specific CECL booked against the $56.9 million office loan in Chicago, ACRE has only reserved 2.2% against the other $766 million in office loans (Figure 5).
Figure 5 - ACRE estimated reserve ratio by property type (Author created with data from company disclosures)
This figure appears low relative to the scale of the challenges facing the office asset class as offices remain the epicenter of investor worries due to soaring vacancy rates from work-from-home ("WFH") trends and companies laying off white-collar workers (Figure 6).
Figure 6 - Offices remain epicenter of investor worries (Financial Times)
ACRE Retrenching, Waiting For Opportunities
As a sign of the challenging macro-economic environment, ACRE also dramatically slowed down the pace of its loan originations, funding just $26 million in new loans versus $836 million in loan repayments and sales (Figure 7).
Figure 7 - ACRE slowing loan originations (ACRE investor presentation)
In fact, the company now has $154 million in unrestricted cash on its balance sheet that can fund up to $475 million in new loans (if levered under ACRE's secured funding agreements) (Figure 8).
Figure 8 - ACRE has $475 million of loan capacity (ACRE investor presentation)
While ACRE has ample capacity, management does not appear eager to fund new loans, with the CEO commenting that " it will undoubtedly take some time for this to play out in the cycle," and that the company will selectively deploy capital in the coming quarters to play " offence when the time is right ".
Maintaining Dividend Is A Key Priority...
Although financial performance was weak, ACRE chose to maintain its $0.35 quarterly dividend ($0.33 regular plus $0.02 supplemental) as management and the board of directors feel that " shareholders, really do want and expect, and deserve regular predictable, recurring cash dividends." As long as the company is able to fund those dividends, ACRE will maintain its dividend policy.
...But May Consider Buybacks
However, with stock trading at ~$8.50 vs. book value of $13.15 / share or 0.65x P/B, management was open to the idea of using some of its cash hoard to buyback deeply discounted shares, in addition to funding its dividend, buying more time to work out distressed loans, and funding new loans.
Conclusion
Overall, my view on ACRE is unchanged after its challenging Q1/earnings. With the economy still weakening and CRE delinquency rates coming off multi-year lows, I believe it is still too early to be constructive on ACRE.
While the company has ample liquidity to fund its generous 15.9% dividend, as we saw this quarter, ACRE's book value can continue to decline as loans are charged off and additional provisions taken. I am particularly worried about ACRE's exposures to the office sub-sector, as it recently took a massive 67% provision against one office loan in Chicago, while the rest of its office portfolio is only reserved at 2.2%.
For further details see:
Ares Commercial Real Estate: CRE Markets Continue To Weaken