Let's get started. I am Derek Hewett, the 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 A-C-R-E. 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?
Yeah, I'll kick it off, and I'll let Tae-Sik weigh in as well. But we recently celebrated our 10-year anniversary of our 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, and really focused on creating an interesting dividend yield for our underlying LPs. As we've grown our equity base, specifically over the last five years, we've continued that with that underlying DNA, but expanded the client base from a sponsorship perspective to, to target more institutional investors as well. Tae-Sik, maybe I'll ask you to give a little bit more history on, on ACRE.
Yeah. No, thank you, Bryan, and, Derek, thanks again for, having us, having us today. Yeah, and as Bryan mentioned, you know, we have a long history of, originating, commercial real estate loans, and I think what differentiates us is that we are a direct originator. You know, 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.
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, you know, intense asset management, that having that direct relationship with the borrower has been crucial to understanding what is going on with the assets and working with the borrowers very closely on any sort of modifications, any other adjustments that they would need.
Okay, great. Thank you. 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 that would be a systemic problem, or is it 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 corporate 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 than might historically have been available. So within the parlance of commercial real estate, core and core plus debt 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, 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 2024 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 sub-sectors.
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. 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 weigh in. I think if you look at the snapshot as of June 30th, Derek, you're right, 38% of our unpaid principal balance is in, is collateralized by office assets. I think there's a little bit of historical perspective. You know, really over the past 18 months, you know, 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 redeploying it, we have either paid down debt or harbored cash, such that, you know, we had over $140 million of cash, $75 million of borrowing capacity on 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 shrunken, you know, on purpose, which has then increased the, you know, 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, you know, 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, you know, 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, 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, you know, 40% of our office loans are rated 4s and 5s. So those are, you know, those are the, you know, very, very close attention. So it is something that, you know, we have deep capabilities, you know, within the Ares corporate structure to, 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. Bryan?
Yeah, 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's the fundamentals of how we use it, and the, 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 posit that if you were to go to a bank, Wells Fargo, Bank of America, money center banks, and ask 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 think we 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 the narrative around the space, while again, there's plenty of unknowns, we are starting to hear those anecdotes of there are unknowns, but somebody's 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 bathwater adage.
Okay. Thank you for that. And then, the second largest asset 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 thing having the capital structures around multifamily because the rent growth, even if you started at that beginning of 2021, was in excess of really what a rational underwriter would have described. So if you were to go to 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 Sunb elt. 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 owner 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 five 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. The supply thing that I mentioned earlier, because of the capital markets changes, mean that you should probably stick around and play out the story. 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 2021 and 2022.
Okay, thank you. 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 peer 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. You know, 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 two loans.
I think we talked about these two loans during our last earnings call, and both of those loans are in the process of being, you know, sold or realized. And I think if you sort of looked at our general reserve, therefore, about 2.5%, I think you'll find that is more in line, Derek, in terms of where some of our commercial mortgage REIT peer group may be. I think there's a bit of a grouping. There are some that are, you know, 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.
I do think it's important to kind of look at it, you know, specific versus general in order to understand the components of our overall 5% CECL reserve.
Okay. Thank you. 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 certain circumstances, maybe a reluctance to hold certain collateral types?
Well, 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, it is a pretty accretive backdrop, given where SOFR is and the, 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, will borrow coming out of this.
But given the dearth of transaction volume, there isn't enough data points 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 spreads 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, that there are quality transactions to be done, and there's quality repo to deploy into those transactions.
While we expect to see further consolidation of the counterparties of the major money center banks, meaning you want to be a part of an Ares of $380 billion institution in order to harvest your share of that warehouse line capital, it is more readily available today than it was 12 months ago.
Okay, thank you for that. And then, ACRE repurchased about 1% of its shares during the first, 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, I can start with that. You know, I think we are in a very good position today, given how much liquidity we have, to really, take advantage of all of those opportunities, right? So we wanna 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 Derek, as you mentioned, in the second quarter, we bought back about 1% of our shares at a very, very big discount to where it's trading today, and certainly at a very big discount to book value per share. And, you know, we find we're in a very good position to be able to really take advantage of all three opportunities, given the liquidity levels. We don't have to decide which one of those three. I think it's just a matter of degree of, you know, how much of, you know, opportunity one, opportunity two, opportunity three should we take advantage of, and it's not either/or. So we find ourselves in a very good spot.
I think, you know, what we said again on our last earnings call is that we'll continue to look for opportunities to do all three, 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. Thank you. And then how is ACRE positioned, today, from a liquidity perspective? Do you, do you have any near-term debt maturities in over the next two to three years? And then just in terms of your, 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?
Yeah. So if you look across our liability structure, none of our warehouse lending facilities have upcoming maturities through 2024. 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 $150 million term loan doesn't come due till 2025. So we do find ourselves in a very good spot in terms of not having any real 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, you know, come to play in the past three years, particularly with the onset of COVID, which is, you know, none of our facilities have a mark-to-market provisions with respect to credit spreads. We do have, you know, 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, you know, reprovisioning of that loan is. But from a spread perspective, there is no, there is no mark-to-market on a credit spread perspective.
Okay. Thank you. 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, can assist with loan resolutions? And is there maybe an example that you'd like to highlight, in terms of, in terms of that aspect?
Sure. Yeah, 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 eight 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, you're 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, last quarter, and where we expected to take that asset REO. That's where we would call in the additional team members of a 45+ person asset management team throughout the country, more focused on, 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 sub-sector 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 gonna bring that those resources to bear.
We think certainly as you go through that decision tree of is the right path to restructure a loan, to sell the note, or foreclose and create additional value for our 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 loan modifications? Or maybe a better way to ask it is, your criteria for doing a loan modification versus taking possession of the asset, or just outright selling of the loan. 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 it require additional proceeds and, and additional spend? And then secondly, and this is somewhat philosophical and somewhat quantitative, but is the counterparty on that loan accretive to the ultimate resolution? And that, that judge of a, accretive might be because of the capital they'll bring to bear 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, a positive outcome, that might lead us down 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 resolve the collateral 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, one, the interest rate environment. It was easier to stick around for some borrowers three years ago or two years ago than it is today. In terms of the spend, it's gonna vary on an asset-to-asset basis. The best example I could give is the Westchester Marriott Hotel that we took REO in the beginning of 2019, and ultimately resolved in early 2022, if I recall, Tae-Sik Yoon. And the value creation, we didn't really have any material spend following taking that asset as REO. There were unique circumstances in terms of the sponsorship where would fall to, to finish the execution of the business plan. But that was almost legal in nature, right?
Moving it from a Marriott managed to a franchised asset, working with our 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, and 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 facility specific for that collateral?
It'll be a case-by-case basis. I think, you know, when we think about our leverage, obviously it was, it was much more appetizing to increase your leverage profile when rates and spreads were lower. We sit here today wanting to be the lender, not the, not the recipient of those funds in those terms. So, as we look, you, you can certainly assume that we will take that asset REO off of a warehouse line or off of an existing facility and rotate it onto some other form of financing, direct, mortgage financing or otherwise.
As you see with our corporate balance sheet, our bend is going to be 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 that you become X-rolled simply because you gave the keys back on a non-recourse financing. I'd say that as we look at some of the facts that have transpired in our market, that there are certain level of sponsors that one might have felt and might have given these sponsors better than market terms, been under the belief that while it is a non-recourse 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 apt to give the keys back earlier on, without truly working through, at least in a sincere way, the proper resolution of the asset.
That's going to lead to people revisiting what the borrowing costs 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. 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, their last three funds have made an 18-20." We'd rather see them make those returns making 16s-24s than 0s and 50s, right? Because as a lender, we're not going to participate in that, that upside of that one-off case that feels more like an operator model. We wanna 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 the one-off asset that gets handed back, that consistency is what we're going to seek out as a lender.
Okay, thank you. And then maybe I'll wrap with a question about the investment thesis. So why is ACRE an attractive investment opportunity?
Yeah, 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 this last COVID crisis that we all went through, you know, ACRE has consistently earned and paid out, you know, its cash dividend. In fact, I think we were one of the very few commercial mortgage REITs to actually have implemented an additional supplemental dividend, for you know, 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 already builds in more than $2 per share in terms of CECL reserve, and yet we're still trading at a, you know, material discount to even our CECL-adjusted book value. So I think that is really the investment thesis that we would encourage our listeners to really evaluate. Bryan?
Yeah, 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 creative 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?
Yeah, I have one. What, what do you generally speaking about office assets, what do you assume is the haircut generally for us?
Just let me repeat the question for the audience. It's just a question about the... In general, what are the haircuts for office collateral in general? Your estimate.
I think you'd be hard-pressed, given the lack of transaction volume and kind of the opaque nature of the, the overall market, to, to put a specific overlay on it.
You get-
Yeah. I think you'd have to go mark-to-market, right? If you were to talk about Downtown Los Angeles, for instance, that's gonna be-
Let's say gateway versus Class A minus, B plus versus suburban.
I think-
Versus what do you think on what percent is going to be kind of absolutely?
It's a great question. I'd say that just quantitatively, just the shift in the capital structure alone for office leads you to believe it's 15-25, before you get to the change in fundamentals. I think that if you are underwriting office today, again, let's take the best of the rest, so not the true trophy Class A built in the last five years, but the types of office buildings that most of us probably circulate in. I think that's off north of 35%, 35%-50%.
That's where you think money maybe change hands?
I think so. I think, you know, again, you have to see that capital continue to be aggregated, and it's tough to, to paint the entire industry with that brush. But certainly, there's going to be compelling opportunities in the sector for equity-type investors.
Maybe if I could go on. When you talk about, you talk about the unpaid balance in office, you talk about percentage of reserves. From the unreserved, I assume it's a blanket, it's not a blanket reserve, it's specific to the asset reserve, right? Whereas the CECL is—Okay, but the question is, for, for what, for what's outstanding in office that's not been reserved against, what percentage of those loans have you seen go to an extension but not reserved? Does that make sense?
Yeah.
I'm going to try to repeat the question, and then-
Yeah, the question was, is what percentage of the office portfolio that does not have a reserve has been extended?
Special mention.
Like, yeah. Yeah.
Not aware of it.
So under CECL, you know, for the general CECL reserve, you know, 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 it 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 think, I guess what I'm trying to think about the reserve again, you know, an IBNR versus a case versus settle. If you ex out the IBNR part, the CECL accounting is reserved, stuff that's actually been approved in the past. If you take what's left of your portfolio, what are you really seeing in terms of, I guess, credit deterioration where you have reserves? And when you talk to them, when you talk to those guys, how are you seeing that be resolved or maybe shadowed? Do you have any kind of-
So what are the attributes... Sorry, do you want to repeat the question or?
Well, there was a lot I want-
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?
That's it. Yeah, that's, that's it.
So I'd say that again, you want whatever capital is being brought to bear to basically service the debt principal or interest in front of the equity. So when you're coming to those conversations, it's for 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 which building has access to 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.