Ares Commercial Real Estate Corporation (ACRE) is a specialty finance company primarily engaged in originating and investing in commercial real estate (CRE) loans and related investments. The company has been navigating through a challenging macroeconomic environment, but its management team remains focused on resolving underperforming loans and positioning the company for future growth.

Financials

In the fiscal year 2023, ACRE reported annual net income of -$38.87 million, annual revenue of $192.08 million, annual operating cash flow of $46.79 million, and annual free cash flow of $46.79 million. The company's quarterly results have been impacted by the ongoing market conditions, but management is taking proactive steps to address the challenges.

Business Overview

ACRE was formed and commenced operations in late 2011 and completed its initial public offering in May 2012. The company is externally managed by Ares Commercial Real Estate Management LLC (ACREM), a subsidiary of Ares Management Corporation (NYSE: ARES), a publicly traded, leading global alternative asset manager.

ACRE's primary focus is on directly originating and managing a diversified portfolio of CRE debt-related investments for its own account. The company's target investments include senior mortgage loans, subordinated debt, preferred equity, mezzanine loans, and other CRE investments, including commercial mortgage-backed securities. These investments are generally held for investment and are secured, directly or indirectly, by office, multifamily, retail, industrial, lodging, self-storage, student housing, residential, and other commercial real estate properties, or by ownership interests therein.

ACRE operates as a real estate investment trust (REIT) for United States federal income tax purposes, commencing with its taxable year ended December 31, 2012. The company generally will not be subject to United States federal income taxes on its REIT taxable income as long as it annually distributes all of its REIT taxable income prior to the deduction for dividends paid to stockholders and complies with various other requirements as a REIT.

Navigating Through Challenging Times

During the first quarter of 2024, ACRE made meaningful progress towards its goal of resolving underperforming loans, reducing the outstanding principal balance of nonaccrual loans by $133 million and reducing its exposure to the commercial office property sector by $70 million, or 8% of its total loans backed by office properties.

The company addressed a total of 4 nonaccrual loans during the first quarter, which increased its distributable earnings, excluding losses, compared to the prior quarter by approximately $0.02 per common share. Additionally, ACRE further deleveraged its balance sheet by $138 million, resulting in total third-party debt of less than $1.5 billion at March 31, 2024.

Loan Portfolio and Asset Quality

As of March 31, 2024, ACRE's portfolio included 44 loans held for investment, excluding 170 loans that were repaid, sold, or converted to real estate owned since inception. The aggregate originated commitment under these loans at closing was approximately $2.2 billion, and the outstanding principal was $2.0 billion.

During the first quarter of 2024, the company funded approximately $13.0 million of outstanding principal and received repayments of $78.4 million of outstanding principal. As of March 31, 2024, 70.0% of ACRE's loans have Secured Overnight Financing Rate (SOFR) floors, with a weighted average floor of 1.17%.

Regarding asset quality, 36 loans totaling $1.5 billion, or 75% of ACRE's loan portfolio, had a risk rating of 3 or better as of March 31, 2024. The majority of these loans are collateralized by multifamily, industrial, self-storage, and hospitality properties. Borrowers continue to be committed to the underlying properties, with over $130 million in additional capital contributed over the past 12 months for loans risk-rated 3 or better.

However, the company also has 8 loans totaling $503 million in outstanding principal balance that are risk-rated 4 or 5, with 77% of this exposure collateralized by office and residential condominium properties. ACRE has a CECL reserve of $141 million, or 6.9% of the outstanding principal balance of its loans held for investment, with $125 million, or 89% of the total reserve, related to its risk-rated 4 or 5 loans.

Resolving Underperforming Loans

ACRE's primary focus remains on resolving its underperforming loans, which has been a key driver of its financial performance in recent quarters. During the first quarter of 2024, the company addressed 4 nonaccrual loans, including:

1. The sale of a $38 million loan backed by a mixed-use property in California that was on nonaccrual. 2. A discounted payoff of a $19 million loan backed by a multifamily property in Washington that was on nonaccrual. 3. The exit of a $57 million Chicago office loan that was on nonaccrual. 4. The restructuring of a $74 million loan backed by a Class A office building in New York City, which resulted in the $59 million A-Note being returned to interest-earning status while the $10 million B-Note remained on nonaccrual.

These actions reduced the outstanding principal balance of loans on nonaccrual by 31% and increased ACRE's distributable earnings, excluding losses, by $0.02 per common share for the first quarter of 2024.

Looking ahead, the company expects to take a $33 million risk-rated 5 loan, backed by an office building in California, as real estate owned (REO) during the second quarter of 2024. Additionally, a $69 million loan to an office property located in North Carolina, which was on nonaccrual, defaulted after the end of the first quarter, and ACRE has begun the process of taking title of the property.

Liquidity

ACRE continues to maintain significant liquidity and has further reduced its third-party debt. Driven by the loan exit activities during the first quarter, the company reduced its outstanding borrowings by $138 million, resulting in total third-party debt of less than $1.5 billion at March 31, 2024.

The company has been proactive in working with its lenders to ensure it has the flexibility to implement its strategy of resolving underperforming loans. ACRE has made amendments to its credit facilities to optimize its balance sheet and maintain good levels of liquidity.

Outlook

ACRE's management team remains cautiously optimistic about the modest recovery it is seeing in the commercial real estate markets, and tightening spreads in the CMBS capital markets are expected to be supportive in the execution of the company's near-term goals.

The timing and path to resolving some of ACRE's current risk-rated 4 and 5 loans may make its quarterly earnings trajectory uneven this year, including in the second quarter due to loan resolutions. However, the company is firmly focused on addressing its underperforming loans and further building liquidity in order to maximize outcomes as it seeks to shift its focus from asset management to investing.

ACRE's management has stated that it remains focused on resolving a number of the identified risk-rated 4 and 5 loans in 2024, which it believes will enable the company to achieve higher distributable earnings.

Risks and Challenges

ACRE's business and financial performance are subject to various risks and challenges, including:

1. Macroeconomic conditions: The company's operations and portfolio are susceptible to changes in the broader economic environment, including high inflation, rising interest rates, and potential market-wide liquidity problems. 2. Commercial real estate market conditions: Volatility and uncertainty in the commercial real estate market, particularly in the office and retail sectors, could adversely impact the value and performance of ACRE's investments. 3. Loan defaults and credit quality: The company's financial results are dependent on the performance of its loan portfolio, and any increase in loan defaults or deterioration in credit quality could negatively affect its earnings and cash flows. 4. Regulatory and legal risks: As a REIT and a specialty finance company, ACRE is subject to various regulatory and legal requirements, which could change over time and impact its operations and compliance costs. 5. Financing and liquidity risks: The company's ability to access financing and maintain adequate liquidity is crucial for its operations, and any disruptions in the credit markets could limit its funding sources.

Conclusion

Ares Commercial Real Estate Corporation is navigating through a challenging macroeconomic environment, but its management team remains focused on resolving underperforming loans and positioning the company for future growth. The company's efforts to reduce its exposure to the office sector, deleverage its balance sheet, and maintain significant liquidity are positive steps in the right direction.

While ACRE's quarterly earnings trajectory may be uneven due to the timing and path of resolving its risk-rated 4 and 5 loans, the company's long-term strategy of shifting its focus from asset management to investing appears to be well-aligned with the current market conditions. Investors should closely monitor ACRE's progress in resolving its underperforming loans and its ability to capitalize on any opportunities that arise in the commercial real estate market.