2023-08-24 15:25:18 ET
Summary
- Commercial real estate markets worldwide are facing challenges as a decade of low borrowing costs comes to an end.
- The UK, US, Continental Europe, and Hong Kong are experiencing issues in their commercial real estate sectors.
- The Ares Commercial Real Estate Corporation is a specialized finance company with a 13% dividend yield, but its sustainability in the current environment is questionable.
Introduction
Right now, I think it's fair to say that commercial real estate ("CRE") is the weak spot of the (global) economy.
Essentially, commercial real estate markets worldwide are under scrutiny as a decade of low borrowing costs is ending abruptly, which is triggering a wave of challenges for this major asset class.
As reported by Bloomberg last month, a number of distinct issues are emerging across various regions, covering office spaces and shopping malls, raising concerns of a widespread crisis that could impact lenders and lead to vacant city centers.
According to the article:
- The UK experienced rapid declines in asset values, particularly in commercial real estate, triggered by government actions leading to a bond market crisis and surging yields.
- In the US, high vacancy rates in office spaces contributed to significant declines in values, resulting in landlords surrendering properties worth less than their secured debt.
- Continental Europe faces concerns over real estate-backed bonds trading at distressed levels, potentially leaving landlords unable to cover the substantial debt due by the end of 2026.
- Hong Kong grapples with a record amount of empty office space as Western banks reduce their presence and Chinese firms fail to fill the void.
As one can imagine, the primary driver behind these challenges is the surge in borrowing costs. Rapid interest rate hikes by central banks have elevated returns on government bonds, causing commercial real estate investors to demand higher yields to justify holding illiquid assets.
Although rising rents can counter some valuation impacts, the significant spike in yields following the end of near-zero rates has overwhelmed most rent increases.
In light of these challenges, I'm dedicating this article to a company I've never covered before. The Ares Commercial Real Estate Corporation ( ACRE ) .
This CRE giant, with a 13% dividend yield, has returned 54% since 2012. Excluding dividends, the return is minus 45%.
In this article, I'll assess the attractiveness of this high-yielder - especially in light of the aforementioned challenges.
So, let's get to it!
What's ACRE?
Ares Commercial Real Estate Corporation is a specialized finance company primarily engaged in originating and investing in CRE loans and related investments.
ACRE operates under the management of Ares Commercial Real Estate Management LLC, a subsidiary of Ares Management Corporation ( ARES ). The company's focus is on directly originating and managing a diversified portfolio of CRE debt-related investments for its own account.
ACRE was established in late 2011 as a Maryland corporation and completed its initial public offering in May 2012. This means we cannot check how it did during the Great Financial Crisis.
The company operates as a REIT and targets borrowers with customized financing needs that are not met by traditional bank or capital markets sources. In other words, borrowers that need help getting access to funding. These deals come with juicy yields but also elevated risks.
Having said that, the current environment is favorable for the company, as rising rates cause companies to seek alternative funding.
Bloomberg
The company's strategy combines direct origination with experienced portfolio management, focusing on borrowers seeking to improve the value of commercial real estate.
How Is ACRE Doing In This Environment?
The company's portfolio consists of 53 loans held for investment.
The majority (98%) of these loans are senior loans, amounting to a principal balance of $2.3 billion. The weighted average unleveraged effective yield of its portfolio is 9.5%, with 38% of its portfolio consisting of office loans. Multifamily real estate loans account for 23% of the company's total loans.
Ares Commercial Real Estate Corporation
In its 2Q23 earnings call , the company noted that non-accrual levels remained stable during the quarter, and the company managed to collect 96% of contractual interest.
However, a decline from 78% to 74% was observed in the portion of the loan portfolio with a risk rating of three or better. This change primarily resulted from two loans experiencing negative migration from risk rating three to four.
- One of these loans was a senior loan of $18.7 million for a multifamily property, which faced a payment default and is now being marketed for sale.
- The second loan, a $68.9 million senior loan for an office property in North Carolina, continued to pay interest while the company explored a potential loan modification.
With this in mind, the company reported a GAAP net loss of $2.2 million, equivalent to $0.04 per common share. This loss was primarily due to a net increase of $2.1 million in the CECL (Current Expected Credit Loss) provision, which translates to $0.37 per common share.
Despite the loss, distributable earnings for the quarter were reported at $19 million, or $0.35 per common share.
These distributable earnings covered both regular and supplemental dividends. I highlighted this in the table below. After all, a provision for credit losses does NOT impact distributable earnings, as it's not a cash outflow.
Ares Commercial Real Estate Corporation
With regard to these expected credit losses, the company's CECL reserve stood at $112 million as of June 30, 2023, equivalent to about 5% of the outstanding principal balance.
Ares Commercial Real Estate Corporation
- Specific reserves of $48 million, accounting for 43% of the total reserves, were allocated to two loans with a risk rating of five. These loans, with a combined principal balance of $92 million, had their specific reserves increased by $4 million due to further clarity on ongoing sales processes.
- The company held $47 million in reserves for eight loans with a risk rating of four, amounting to roughly 9.5% of the total outstanding principal balance for these loans.
- The remaining CECL reserve of $17 million was for loans rated three or better, equal to around 1% of their outstanding principal balance.
While these numbers aren't a reason for panic, I'm not a fan of these developments and believe that CECL provisions will have to rise further. Rates are likely to remain elevated unless something triggers the Fed to cut rates. That something could very well be commercial real estate.
Having said that, the company has a strong balance sheet itself, with more than $215 million in available capital as of June 30, 2023.
This amount includes $143 million in cash, along with additional funds accessible through the working capital facility.
Ares Commercial Real Estate Corporation
The net debt-to-equity ratio remained stable at 1.9x.
ACRE also got an extension of the $250 million Morgan Stanley credit facility to July 2025.
Regarding the dividend, the company had been distributing supplemental (special) dividends of $0.02 per quarter, totaling more than $10 million over ten consecutive quarters, in addition to the regular base dividend of $0.33 per quarter.
In other words, the elevated rate environment has translated into higher income right from the start.
However, due to the changing landscape, the company decided to cease the supplemental dividend payments.
This decision was motivated by the cessation of in-the-money LIBOR floors on loans and the winding down of interest rate swaps.
As we forecasted and in accordance with business plan, the LIBOR floors on our loans are no longer in the money and our interest rate swaps have mostly wind down. After careful consideration, going forward, we believe that it is in the best interest of ACRE and our shareholders that rather than continuing to pay the supplemental $0.02 per quarter dividend that we instead focus on preserving capital to provide us with the opportunity to make further common share repurchases and originate new loan investments. - ACRE 2Q23 Earnings Call
The company's focus has shifted towards capital preservation, common share repurchases, and originating new loan investments.
In the second quarter, the company had already repurchased $4.6 million of common shares, exceeding four quarters of the previously paid $0.02 per quarter supplemental dividends.
Based on a $0.33 quarterly dividend, ACRE shares yield 13.4%.
Valuation
ACRE is trading at 78% of its book value. Prior to the pandemic, the company was consistently trading at 90% of its book value.
A 10% discount is fair, given the elevated risks that come with CRE loans.
Right now, there is a case to be made that ACRE is trading below its fair value. If we apply the same 10% discount, we would get an $11.50 target price.
However, I cannot make the case that this is warranted.
Feel free to disagree with me, but I do not trust this CRE environment. I believe that a bigger discount is fully warranted.
So far, the base dividend is not at risk. However, if the Fed is forced to maintain elevated rates, I believe we will see a lot more debt failures in the CRE space.
While Ares is certainly one of the best management companies in the world, it's not an environment I want to be in - not even if the yield is juicy.
In other words, as much as I respect Ares and believe that it does pick the best (high-risk) CRE deals on the market, this isn't a company I want to be in right now. Nor will I buy it for some of the yield-focused portfolios that I advise.
Takeaway
Amidst a backdrop of rising borrowing costs and uncertain market conditions, ACRE's 13% dividend yield drew my attention.
This specialized finance company navigates the challenges by directly originating and managing a diversified portfolio of CRE debt-related investments.
Despite resilience with stable non-accrual levels and strong distributable earnings, the company's cautious shift toward capital preservation raises questions.
Although ACRE is a strong player in high-risk commercial real estate, the current environment raises concerns about its sustainability.
The attractiveness of high yields must be weighed against the unpredictable nature of the commercial real estate market, which leads me to believe that ACRE deserves to trade at a significant discount - at least for the time being.
For further details see:
Ares Commercial Real Estate: Yielding 13% With Significant Risks