Ares Commercial Real Estate Corporation (ACRE) Earnings Call Transcript & Summary

Let's get started. I am Derek Hewett Bank of America senior equity analyst covering specialty finance sector, including commercial mortgage REITs. With us today is Bryan Donohoe, CEO; and Tae-Sik Yoon, CFO of Ares Commercial Real Estate, That's ticker ACRE. Thank you for joining us today. So maybe first, Bryan, would you spend a few minutes providing a brief overview of ACRE and not only discussing the lending strategy, but also the company's competitive advantages.

Yes, I'll kick it off and I'll let Tae-Sik way in as well. But we recently celebrated our 10-year anniversary regard listing on the New York Stock Exchange. So we've been in business for that period of time, really targeting initially middle market real estate opportunities and really focused on creating an interesting dividend yield for underlying LPs. As we've grown our equity base specifically over the last 5 years, we've continued that with that underlying D&A but expanded the client base from a sponsorship perspective to target more institutional investors as well.

Tae-Sik, maybe I'll ask you to give a little bit more history on ACRES.

Yes. No, thank you, Bryan. And Derek, thanks again for having us today. As Bryan mentioned, we have a long history of originating real estate loans. And I think what differentiates us is that we are a direct originator we have offices throughout the U.S. And what we pride ourselves on doing is having that direct relationship with the borrowers not only on originations, but continued asset management and we think by having that, again, direct relationship with the borrower, we are getting better pricing, we're getting better terms. And we're finding that during this period of intense asset management that having that direct relationship with the borrower as a crucial to understanding what is going on with the assets and working with the borrowers very closely on any sort of modifications any other distance that they would need.

Okay. Great. And then how would you describe the current macro backdrop for commercial real estate? And more importantly, how is ACRE positioned just given that the overarching question seems to be these days that is there a looming CRE cycle that's be a systemic problem or an issue that the CRE cycle is an issue but is very much manageable.

I think you'd hear it throughout all of Ares from poor credit and direct lending to private equity real estate equity and real estate credit. A familiar theme that we are certainly entering a new credit cycle. And from a vintage perspective, we certainly believe that we're entering a very interesting time for our investors and to be able to create very interesting yield opportunities at safer parts of the capital structure that might historically have been available. So within the parlance of commercial real estate, core and core plus that today is pricing like value-add and opportunistic and the LP community is seeing that opportunity set. From an underlying fundamental perspective, and then we'll touch on the economic backdrop, but we sit here today with muted supply growth, which has typically been the catalyst for that onset of a new credit cycle specific to commercial real estate. And we might not have been able to say that absent the banking crisis that we've seen over the past call it, 18 months. But the capital structure shift, owing both to the increase in SOFR alongside more restricted credit processes at the banks means that the supply issues that might have come second half of '24 for industrial or apartments really has become somewhat muted. And so you're seeing high rates of renewals, you're seeing continued rent increases or more normal rent increases than what we had in those subsectors. And so the headlines and the headwinds in commercial real estate remain fairly concentrated within the office sector, which we've obviously spent a good bit of time discussing over the past 18 months. So largely throughout our space, we're going to see this more of an opportunity as we navigate the headwinds associated with the office sector.

Okay. And then just given that office is the most stressed collateral type, ACRE's exposure to office is relatively high about 38% versus the overall peer average, that's in the mid-20s. So how should investors view ACRE's office exposure?

Derek, I can start. And Bryan, please way in. If you look at the snapshot as of June 30, Derek, you're 38% of our unpaid principal balances is collateralized by office. I think there's a little bit of historical perspective. Really, over the past 18 months, we've taken a very conscious effort to start to deleverage our balance sheet so that when we've had loan repayments in the past 18 months rather than replaying we have either paid down debt or harbored cash such that we had over $140 million of cash, $75 million of borrowing capacity under our lines. But what that has meant is what are the denominator impact on our portfolio. So the loans that have paid off, unfortunately, have not been office assets. So while we haven't really originated many new office assets, it's really the denominator that has shrunk in on purpose, which has then increased percentage of office exposure. In terms of how we're treating it and looking at it, obviously, with what everyone knows is going on in the office sector, we have been very, very focused on the office loans that we have. And we think we have properly reserved for those assets and properly rated those assets. So for example, about 2/3 of our CECL reserve is on our office assets. So even though our office assets is 38% of our portfolio, 67% of our CECL reserve is on office. So that's certainly one way. And then when we really look at the time and attention and the focus that our team is spending on office assets. Again, I would say about 40% of our office loans are rated 4s and 5s. So those are very, very close attention. So it is something that we have deep capabilities within the Ares corporate structure to work with. But it is certainly something that we are very focused on in terms of managing the collateral through a very volatile market condition.

Yes. And maybe I'll pile on just a little bit, which is there are plenty of unknowns out there in the office sector today, whether that the fundamentals of how we use it and when I say we, it's the collective we because each of us are behaving a little bit differently as it relates to our relationship with office product or the way capital treats it. I would pause it that if you were to go to a bank, Wells Fargo, Bank of America, money center banks and asked for an office loan, that decision is going to go to the highest ranks because every research analyst call is raising what's your office exposure. So how is that narrative evolving? I don't necessarily have yet to see banks return to the space. But from a fundamental perspective, the train parking lots are more full, the trains are more full. You're starting to see potentially a trough in actual utilization, if not occupancy and a narrative around the space, while again, there's plenty of unknowns. We are starting to hear those anecdotes of -- there are unknowns, but somebody is going to make a lot of money in the recovery in this space. And I don't have anything to point to directly yet, but I think you're going to start to see capital be aggregated in the office sector to take advantage of the old baby with the bass water outage.

Okay. And then the second largest [indiscernible] type is multifamily at roughly 23% or so. What is your outlook for the multifamily sector and are you worried about maybe the 2021 or maybe early 2022 vintages when property values were extremely elevated relative to where they are today.

It's a great question. I would say that there's in general, there's pretty decent [ banking ] capital structures around multifamily because the rent growth, even if you started at that beginning of '21 was in excess of really what a rational underwriter would have ascribed. So if you were to go through the mortgage REIT space or private lenders, you never would have seen someone underwrite double-digit rent growth on an apartment complex, and that's what we saw, especially in the Sunbelt. So the fact that, that's returning to a little bit more normalcy. Certainly, we'd all love to see growth from the lender or property perspective, but there's really a rational give and take back in that market landscape. The capital structure certainly was not envisioned to have a 5 handle on SOFR, if you were one of those aggressive buyers you're intimating, Derek. I think that there's structural components within these loans that offer some protection. And the supply being that I mentioned earlier because of the capital markets changes, mean that you should probably stick around and play out the story, and there remains a structural shortage of housing in the United States, and apartments are going to be the most efficient way to alleviate some of that. And they'll certainly continue to harvest the rent available, albeit a little bit more rational than it was in '21 and '22.

Okay. And then circling back to your credit reserve, the CECL reserve is roughly 5% of the portfolio, a significant portion of that is going to be office. That being said, it's about double the overall pure average for a commercial mortgage REIT. So how should investors look at your CECL reserve relative to peers or and then also, what are your thoughts in terms of the reserve going forward?

Sure. Great question, Derek. I think it's important to break down the 5% CECL reserve, as you mentioned, into its various components. About half of that is made up of specific reserves on 2 loans. I think we talked about these 2 loans during our last earnings call. And both of those loans are in the process of being sold or realized. And I think if you sort of looked at our general reserve therefore about 2.5% in you'll find that is more in line in terms of where some of our commercial mortgage rate peer group may be. I think there's a bit of a grouping. There are some that are well under 100 basis points. There's another grouping that are kind of in that 2.5% range in terms of general reserve. And I think we're in that second group. And I do think it's important to kind of look at it specific versus general in order to understand the components of our overall 5% CECL reserve.

Okay. And then moving on to funding. What is the funding environment like? And are you still finding lenders that are willing to fund on more standardized terms? Or are you starting to see any sort of pullback from the banks and your other counterparties, whether it's either advance rates or spreads or in circumstances maybe a reluctance to hold certain collateral types.

Let's carve out office for this part of the conversation, if you don't mind Derek, because I think that still has the headwinds from a financing perspective, as I mentioned. But it is a pretty accretive backdrop given where SOFR is and the treatment from a risk-based capital perspective that the banks get for warehouse lines and the like. And you combine that with the underlying fundamentals that I mentioned earlier. A deleveraged capital structure that we're seeing throughout the space. And I think the backdrop is there for some positive outcomes with respect to how we or our industry will borrow coming out of this. Given the dearth of transaction volume, there's enough data point that I can point you to, but it does feel as if you're actually starting to see some competitiveness return to the warehouse line market and spread is actually compressing to some degree. We can look out at the conduit CMBS market or the SASB market, and there's probably some technical tightening there. But the conversations with the counterparts of the mortgage REIT sector at the bank, certainly, they are more productive than they were I think there's a bit of FOMO there of there are quality transactions to be done, and there's quality repo to deploy into those transactions. So while we expect to see further consolidation of the counterparts of the major money center banks, meaning you want to be a part of an Ares of $380 billion solution in order to harvest your share of that warehouse line capital. It is more readily available today than it was 12 months ago.

Okay. And then ACRE repurchased about 1% of its shares during the second quarter. How do you balance holding excess liquidity versus maybe accretive share buybacks, given the discount valuation in the shares right now?

Sure. I can start with that. I think we are in a very good position to get liquidity we have to really take advantage of all of those opportunities, right? So we want to make sure we have adequate liquidity to have the flexibility in working with underperforming loans. That's certainly first and foremost. We continue to be very active out in the market looking for the right origination opportunities, and we have done some of that, albeit at a much lower pace than maybe in a normalized market. And then really the third use of capital that we have taken advantage of is share buybacks. So as you mentioned, in the second quarter, we bought back about 1% of our shares on a very, very big discount to where it's trading today and certainly a very big discount to book value per share. and we find we're in a very good position to be able to really take advantage of all 3 opportunities given the liquidity level. So we don't have to decide which one of those I think it's just a matter of degree of how much of opportunity 1 opportunity 2, opportunity 3 should we take advantage of, and it's not either or. So we find ourselves in a very good spot. I think what we said again in our last earnings call is that we'll continue to look for opportunities to do all 3, including share buybacks. And one of the things that we have also done is just given the history of our so-called $0.02 supplemental dividend, which really in the most recent quarter, again, we announced that we will start to take that capital and really try to focus that on the other opportunities of loan originations and share buybacks.

Okay. And then how is ACRE positioned today from a liquidity perspective? Do you have any near-term debt maturities over the next 2 to 3 years? And then just in terms of your funding, do you have any sort of mark-to-market provisions for -- in your credit facilities for either spreads or is it just credit?

Yes. So if you look across our liability structure, none of our warehouse lending facilities have upcoming maturities through the '24. One of our revolving credit lines with City National Bank that is coming due, but we do have ongoing discussions. There is nothing outstanding under that facility. But we do have one maturity coming up. And then our [ $115 ] term loan doesn't come due until 2025. So we do find ourselves in a very good spot in terms of not having individual upcoming debt maturities. And then in response to really your second question about how our warehouse facilities work. Again, I think this is an extremely important distinction and one that we saw come to play in the past 3 years, particularly with the onset of COVID, which is none of our facilities have a mark-to-market provisions with respect to credit spreads. We do have margin in case there's a credit event. So an actual credit event happens at the property and we will enter into discussions with our warehouse lenders to see what the right reprovisioning of that loan is. But from a spread perspective, there is no mark-to-market on a credit spread perspective.

Okay. And then it was mentioned earlier that asset management in this type of environment is a big focus so could you talk about the asset management group and how the overall Ares platform can assist with loan resolutions? And is there maybe an example that you like to highlight in terms of that aspect?

Sure. Yes, it's a great question and certainly a differentiating feature for us. I think, Derek, I mentioned the importance of scale as it relates to our borrowing and I think scale is important as it relates to asset management. So ACRE and real estate debt sits within a $50 billion AUM sector at Ares, where we invest in equity and debt throughout the U.S. and Europe. From an asset management perspective, specific to the debt team, we have a team of 8 to 10 folks throughout the country that work with our borrowers and really given the value-add nature of what we lend on throughout ACRE that is a pretty active asset management. So conversations that become more acute, the higher the risk rating, but certainly, talking to every borrower every month to understand the progression of that business plan. When we come to those more acute situations, and I think we discussed this with respect to the asset that we discussed. The mixed-use asset in Florida we chatted about last quarter and where we expected to take that asset REO. That's where we would call it the additional team members of a 45-plus person asset management team throughout the country, more focused on the equity side of the business. And while there's generalists on that team that can help through real estate as a whole, there's also subsector specialists that might have the relationships and expertise in retail, in office in industrial in the apartment sector. So when we start to have those more acute conversations with the borrower, we're going to bring that -- those resources to bear, and we think, certainly, as you go through that decision tree of this is the right path to restructure a loan to sell the note or foreclose and create additional value for underlying shareholders. Each of those team members will be brought together to come to the best solution.

Okay. And then in terms of -- you had mentioned loan modifications. What are some of the key themes that investors need to look out for? And then what are your criteria for doing modifications or maybe the other way to ask it is, you're quite curious for doing a loan modification versus taking possession of the asset or just like selling of the loans. So what do you look for in terms of making those decisions?

I'll start at the high level, which is to say, is it going to be capital intensive from here, number one? Will you -- will it require additional proceeds and additional spend? And then secondly, and this is somewhat philosophical somewhat quantitative, but is the counterparty on that loan accretive to the ultimate resolution. And that judge of accretive might be because of the capital they'll bring to bare or specific expertise that they can truly drive value. But absent seeing a borrower that's going to contribute one way or another to a positive outcome that might lead us down in the more difficult path. That said, we sit here as obviously a very large player in the credit community throughout corporate credit and real estate. Our bend is always going to be that we would rather not step in but certainly, we need the capability to do so and to take over the asset. So it really comes down to a little bit of quantitative , a little bit of qualitative judgment.

Okay. And then under kind of a worst-case scenario, where it makes sense to take over a particular piece of collateral. How should investors think about that incremental spend to fully resolved lateral and exit at a certain point. Is there -- aside from like the transfer taxes or can you think about it from an additional percentage of the original loan as a way to kind of think about the incremental capital that's needed to resolve the credit?

It really varies based on the interest rate [indiscernible] it was easier to stick around for some borrowers 3 years ago or 2 years ago than it is today. In terms of the spend, it's going to vary on an asset to asset base. The best example I could give is the Westchester Marriott hotel that we took REO beginning of 2019 and ultimately resolve in early '22, if I recall, Tae-Sik and the value creation, we didn't really have any material spend following taking that asset as REO. There are unique circumstances in terms of the sponsorship would fall to finish the execution of the business plan. But that was almost legal in nature, right, moving it from a Marriott managed to a franchise asset working relationships throughout the corporate infrastructure of Marriott itself to create value and ultimately resolve that asset at the earliest possible time coming out of COVID than we did so above our carrying value. So it's not necessarily the case that there will be a spend you can just assume that we are going to work to mute that spend over time.

Okay. And then just in terms of financing those types of transactions, will you put it on an existing facility? Or will you get a new specialty specific for that collateral?

It will be a case-by-case basis, I think, when we think about our leverage, obviously, it was much more appetizing to increase your leverage profile when rates and spreads were lower. And we sit here today wanting to be the lender not the recipient of those terms. So as we look, you can certainly assume that we will take that asset REO off of a warehouse line or off of an existing facility and rotated onto some other form of direct mortgage financing or otherwise. And as you see with our corporate balance sheet, our bend is going to be more moderately levered than some others might choose to be under the guise that we are charged with creating a consistent dividend for our LPs and increase or excess leverage doesn't necessarily work to benefit that charge.

Okay. That was very helpful. And then what is your willingness to work with sponsors that do end up handing you the keys? How do you kind of evaluate whether you want to kind of work with that sponsor again?

It's certainly a factor. I don't know that it's a -- that you become ex-rolled simply because you give the keys back on that nonrecourse financing. I'd say that as we look at the -- some of the facts that have transpired in our market that there are certain level of sponsor that, one might have felt and might have given these sponsors better than market terms under the belief that while it is a nonrecourse financing, there is a franchise to protect. And I think what we're seeing in this cycle given the increased carry costs associated with SOFR and the potential refinancing of those existing assets. You're seeing some sponsors that are more act to give the keys back earlier on without truly working through, at least in a sincere way. the proper resolution of the asset. And that's going to lead to people revisiting what the borrowing cost should be for those counterparts. Look, we all make mistakes, equity, debt, et cetera. But that track record is something that we pay a lot of attention to. And I'll take it one step further. One of the things we want to see, it's great if you can look at a counterpart and say, wow, the last 3 funds have made in 18 to a 20 we'd rather see them make those returns making 16 to 24 than 0s and 50s, right? Because as a lender, we're not going to participate in that upside of that one-off case that feels more like an operator model, we want to see consistent risk-based asset management and risk-based allocation of capital to do what you said you were going to do for your investors. And so that more than just a one-off asset that gets handed back, that consistency is what we're going to seek out as a lender.

Okay. And then maybe I'll wrap with a question about the investment thesis. So why is ACRE an attractive investment opportunity?

Yes, I can start. I think when you look at our company's history, when you look at the management capabilities we have being part of Ares management, I think if you look at the balance sheet structure that we have created versus the consistent dividend that we have paid. So as an example, even through last COVID prices that we all went through. ACRE has consistently earned paid out its cash dividend. In fact, I think we were on the very few commercial mortgage REITs actually have implemented an additional supplemental dividend for the past several quarters. And really relative to where we're trading today versus what we think is maybe the more inherent value of the company. I think that really is the investment thesis. Even our book value today builds it in more than $2 per share in terms of CECL resume. And yet we're still treating at a or discount to even our CECL adjusted book value I think that is really the investment thesis that we would encourage shareholders to really evaluate, Bryan?

Yes. And I'll just add. I think from a macro backdrop perspective, the fact is that banks and insurance companies will continue to be important partners of private real estate lenders, but there's still more white space for us to fill in following the incorporation of Dodd-Frank 12, 13 years ago. So I think the landscape is becoming more and more accretive for private lenders to partner with banks and take advantage of the yield environment that we have in front of us. And then from specific to ACRE and to Ares, I think that being a part of the franchise of a large alternative asset manager is going to give us distinct advantages in this next part of the credit cycle that we mentioned that we feel we're at the onset of.

Okay. Great. Are there any questions from the audience?

What do you speaking about office asset, would you assume this is [indiscernible]

And just let me repeat the question for the audiences. Just a question about the -- in general, what are the haircuts for office collateral in general? Your estimate.

I think you'd be hard given the lack of transaction volume and kind of the opaque nature of the overall market to put a specific overlay on it. I think you'd have to go market to market, right? If you were to talk about downtown Los Angeles, for instance, that's going to be.

Let's say, gateway versus class [indiscernible] versus suburban versus what you think what percent is going to be kind of [indiscernible]

It's a great question. I'd say that just quantitatively, just a shift in the capital structure alone for office leads you to believe it's 15 to 25 before you get to the change in fundamentals. I think that if you're underwriting office today, again, let's take the best of the rest. Not the true trophy Class A built in the last 5 years, but the types of office buildings that most of us probably matriculate in I think that's off north of 35% to 50%.

That's where you think money may change?

I think so. I think, again, you have to see that capital continue to be aggregated and it's tough to paint the entire industry with that brush. But certainly, there's going to be compelling opportunities in the sector for equity-type investors.

When you talk about -- you talked about the pay balance obviously talk about the tariffs. From the unreserved [indiscernible] specific to the research [indiscernible] but the question is for what's out saying office, it's not been reserve against. What percentage of those loans have you seen extension [indiscernible] That makes sense?

Yes, I'm going to try to repeat your question and then.

Yes. The question was, what percentage of the office portfolio that does not have a reserve has been extended?

Were good.

Yes. So under CECL, we -- for the general CECL reserve, all loans are going to be part of that reserve. When you talk about specific CECL reserve, obviously, those are going to be unique and identifiable to the particular loans themselves. So there's not a real direct correlation, if you want to call that, between loans that have been modified versus CECL reserve. Certainly, there is some connection, right, meaning that if a loan is being modified because there's a challenge with the asset, that same set of metrics that go to the challenge would be incorporated into the CECL reserve.

I guess I'm thinking about is there any [indiscernible] has reserved some has actually been on in the past. Do you take what's left in your portfolio? [indiscernible] What are you seeing in terms of, I guess, credit deterioration that you had [indiscernible] when you talk to them to those guys, how is that? How are you seeing that or so? [indiscernible]

Sorry, do you want to repeat the question?

Well, there was a lot. I think the question is effectively what are the attributes of an amendment around an extension of an office loan that either is coming to fruition or being discussed. Is that fair? So I'd say that again, you want -- whatever capital is being brought to bare to basically service the debt principal or interest in front of the equity. So when you're coming to those conversations, it's the vast majority is let's rightsize the capital structure to the degree you're capable of doing so. Let's make sure there's money for TIs because that -- your question about office value, I think that bifurcation is going to continue to widen, not based on what's a good building or a bad building, but which building has the capital. So when you get to that discussion that you're having it -- you want to make sure you're approaching something with a long-term solution to the leasing market we're entering, and historical precedent might not be the best way to go about it.

Any other questions? Okay. Thank you very much, gentlemen.

Thank you.

Thank you. Appreciate it.