Ares Commercial Real Estate Corporation

Good morning and welcome to the Aries Commercial Real Estate Corporation's first quarter earnings conference call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Thursday, May 9th, 2024. I would now turn the call over to Mr. John Stillmar, partner of Public Markets Investor Relations. Please go ahead.

Good morning and thank you for joining us on today's conference call. I'm joined today by our CEO, Brian Donahoe, our CFO, Tasek Yoon, and other members of the management team. In addition to our press release and the 10-Q that we filed with the SEC, we've posted an earnings presentation under the investor resources section of our website at www.arescre.com. Before we begin, I want to remind everyone that comments made during the course of this conference call and webcast, as well as the accompanying documents, contain forward-looking statements that are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, and similar such expressions. These forward-looking statements are based on management's current expectation of market conditions and management's judgment. The statements are not guarantees if future performance, condition, or results involve a number of risks and uncertainties. The company's actual results could differ materially from those expressed in the forward-looking statements. As a result of a number of factors, including those listed in its SEC filing. ARIES Commercial Real Estate assumes no obligation to update any such forward-looking statements. During this call, we will refer to certain non-GAAP financial measures. We use these as a measure of operating performance. These measures should not be considered in isolation from or to substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like-titled measures used by other companies. Now, I'd like to turn the call over to our CEO, Brian Donahoe. Brian? Thank you, John.

During the first quarter, we made meaningful progress towards our goal of resolving underperforming loans, reducing the outstanding principal balance of non-accrual loans by $133 million, as well as reducing our exposure to the commercial office property sector by $70 million, or 8% of our total loans backed by office properties. By addressing a total of four non-accrual loans during the first quarter, we increased our distributable earnings, excluding losses, compared to the prior quarter by approximately two cents per common share and further delevered our balance sheet by $138 million to an outstanding balance of less than $1.5 billion at the end of the first quarter. Our focus remains on returning Acre to its core business of originating loans and managing a portfolio of loans backed by commercial real estate properties in order to earn consistent income to support an attractive level of dividends for our shareholders. Let me now provide more details on the loans that were resolved during the first quarter. First, we sold a $38 million loan that we held for sale at year-end 2023 that was backed by a mixed-use property located in California that was on non-accrual. Second, we agreed to a discounted loan payoff of a $19 million loan backed by a multifamily property located in the state of Washington that was on non-accrual at the end of 2023. As a result of these initiatives, We realized a loss consistent with the fair value mark and lost reserves held on our balance sheet at year-end 2023 and paid down $54 million of debt in our FL-4 securitization. Third, we exited a $57 million Chicago risk-rated five loan collateralized by a commercial office property that was also on non-accrual at year-end 2023. As a result of this disposition, we realized a loss that was $3 million higher than the loss reserve held against this loan at year-end 2023. And finally, we restructured a $74 million loan backed by a Class A newly rebuilt office building located in New York City. At closing of this restructure, the borrower paid down $5 million of principal, reducing the balance to $69 million. which was split between a $59 million A note and a $10 million B note. In addition, it is anticipated that the borrower will contribute additional capital into the building for additional new leasing costs, including tenant improvement allowances. To incentivize the contribution of additional capital, including the initial $5 million repayment of the loan, we have agreed to subordinate our $10 million B note to new equity contributed by the sponsor. This restructuring resulted in returning the $59 million A note to interest earning status, while the B note remains on non-accrual. As a result of addressing these four loans, the outstanding principal balance of loans on non-accrual was reduced by 31%, and our distributable earnings losses increased by two cents per common share for the first quarter of 2024. Shifting now to our overall portfolio, we ended the quarter with $2 billion of outstanding principal balance across 44 loans. Thirty-six loans, totaling $1.5 billion, or 75% of our loan portfolio, had a risk rating of three or better. The majority of these loans are collateralized by multifamily, industrial, self-storage, and hospitality properties. As a reflection of the quality of our risk-rated three or better loans, borrowers continue to be committed to these underlying properties. Over the past 12 months, borrowers have contributed more than $130 million in additional capital relating to loans risk-rated three or better And during the same time period, all interest rate caps have been renewed at their prior strike or economically equivalent amounts have been deposited into reserves. Going forward, we will continue to focus on resolving our remaining four and five risk-rated loans and to reduce our office exposure. During the second quarter, we expect to take a $33 million risk-rated five loan backed by an office building in California as REO that is currently on non-accrual. At this time, we believe that our loss reserve on this loan is substantially in line with our current estimate of a potential realized loss. Additionally, despite ongoing negotiations with the borrower, a $69 million loan to an office property located in North Carolina, currently on non-accrual, defaulted after quarter end. We've begun the process of taking title of the office property, and importantly, this property is cash flowing such that if and when the property becomes REO, property level earnings will be recognized. With that, let me turn the call over to Tasek to provide more details on our financial results and balance sheet positioning.

Thank you, Brian, and good morning, everyone. For the first quarter of 2024, we reported a gap net loss of $12.3 million, or $0.23 per common share. Our distributable earnings loss for the first quarter of 2024 was $33.5 million, or $0.62 per common share, and was driven by a realized loss of $45.7 million, or $0.84 per common share, due to exiting the three loans that Brian mentioned earlier. Distributable earnings excluding these realized losses were at $12.2 million or $0.22 per common share for the first quarter. Our overall CISO reserve now stands at $141 million, which declined by $22 million versus the $163 million CISO reserve we held as of December 31, 2023. This reduction was driven by a $42 million reversal of existing reserves associated with the realization of losses, partially offset by approximately $20 million of additional reserves on existing loans in the portfolio. The overall CESA reserve of $141 million at quarter end represents 6.9% of the outstanding principal balance of our loans held for investment, which is down from 7.6% as of the prior quarter. Eighty-nine percent of our total CESA reserve, or $125 million, relates to our risk-rated four or five loans, including 31 million of lost reserves on our two risk-rated five loans, and 94 million of lost reserves on our six risk-rated four loans. Overall, the 125 million of reserves on our risk-rated four or five loans represents 25% of the outstanding principal balance of such loans. Further, with respect to our loans that are risk-rated four or five at quarter end, there were eight loans totaling 503 million in outstanding principal balance. 77% of the outstanding principal balance of our risk-rated four or five loans are collateralized by office and one residential condominium property. We did downgrade one 97.5 million Texas multifamily loan to a risk rating of four from three during the first quarter as the timeline and process of the sale of the underlying property by the borrower has been extended. Before concluding, I want to provide more background on managing our balance sheet. Consistent with our goals, we continue to maintain significant liquidity and further reduce our third-party debt. Driven by the loan exit activities during the first quarter, we reduced our outstanding borrowings by $138 million, resulting in total third-party debt of less than $1.5 billion at March 31, 2024. And finally, we declared a regular cash dividend of $0.25 per common share for the second quarter of 2024. The second quarter dividend will be payable on July 16, 2024, to common stockholders of record as of June 28, 2024. With that, I will turn the call back over to Brian for some closing remarks.

Thank you, Tasik. We are cautiously optimistic that the modest recovery we are seeing in the commercial real estate markets and tightening spreads in the CMBS capital markets will be supportive in the execution of our near-term goals. We are firmly focused on addressing our underperforming loans and further building liquidity in order to maximize outcomes as we seek to shift our focus from asset management to investing. The timing and path to resolving some of our current four and five risk-rated loans may make our quarterly earnings trajectory uneven this year, including in the second quarter due to loan resolutions. We remain focused on resolving a number of the identified risk-rated four and five loans in 2024 which we believe will enable us to achieve higher distributable earnings. As always, we appreciate you joining our call today, and we'd be happy to open the line for questions. Operator?

Thank you. And at this time, if you would like to ask a question, please press star 1 on your telephone keypad. You may remove yourself from the queue at any time by pressing star 2. Once again, that is star 1 to ask a question. And our first question will come from Doug Harder with UBS. Please go ahead.

Thanks, and good morning. You know, you talked about using the, you know, potentially going back to investing, you know, this quarter you used the resolution proceeds to pay down debt. You know, just how should we think about, you know, when you might pivot to investing versus continuing to deliver the balance sheet?

Yeah, I appreciate the question, Doug. Good to hear from you. I think the playbook remains fairly similar to what we've said in prior quarters, which is a multi-pronged path towards resolution where we're considering a lot of options with the pursuit of generating more liquidity which will give us then the optionality as to when we see the opportunities which have started to to present themselves beginning in q4 with some of the rate stability we saw a bit of a pause with the rate movement of the past six or eight weeks But ultimately, we are seeing more liquidity, more acceptance of revised asset values. And ultimately, as we work through the coming quarters, we would intend to get back to that offensive side of the ledger once we've crystallized some more liquidity on the balance sheet. So the primary goal is to continue to resolve those risk-rated four and fives, and the liquidity that should come with those types of resolutions will allow us that flexibility.

I appreciate that, Brian. And, Tasik, can you give us some sense what sort of drag – the four resolved loans, you know, excluding the losses, had on earnings during the first quarter and, you know, kind of had to think about the path back towards the dividend?

Sure. Thanks for your question, Doug. You know, as we mentioned, you know, the four loans that were either exited or restructured this quarter. So really the resolution of those four loans, either through, for example, the restructured loan having an A note come back on earnings, and then the three exited loans really paying down debt. The combination of that really added around two cents of distributable earnings during the first quarter. You know, that run rate, if you want to call it that, you know, the full quarter impact of that, you know, would be higher than the two cents. But for the first quarter, I think it was roughly two cents positive impact that it had on our first quarter earnings. Great.

Thank you, Jason.

Thank you, Doug.

Our next question will come from Jade Romani with KBW. Please go ahead.

This is actually Jason Sapshon for J.A. Romani. It would be helpful to hear an update on how things are going with your repo lenders and on the term loan.

Sure. Good morning.

Do you want to kick off?

Yeah. No, thank you. Thanks for the question. You know, I think we've had and always maintain what we think is a very strong relationship with all of our lenders, warehouse lenders, terminal lenders, revolving credit facility lenders. And, in fact, as you'll notice in our filing this morning, you know, we have continued to work with them and we greatly appreciate the partnership we have with all of our lenders. But you can see that we continue to, for example, amend our credit facility so that we can, again, as part of our overall goal to resolve underperforming loans, optimize the balance sheet with flexibility. So flexibility is very important to us. And again, we appreciate all the partnership we've had, our lenders who have been willing to work with us to create that additional flexibility on our balance sheet.

Great. Thank you. Also, on the North Carolina office loan default, it would be helpful to hear more color on how you see that playing out.

Yeah, I'll give that a shot. I think, look, we obviously were attempting to work with the borrower, however, the capital necessary for us to restructure that loan. And in keeping with what we accomplished on the New York loan that we covered in the prepared remarks didn't necessarily make it rational. It's also an asset, as we mentioned, that has positive cash flow, probably has some occupancy upside in a market that has seen some positive flows of corporate tenancy. So, we think there's some value to be added with a functional ownership group. So I think the timeline for resolution there will be what it will be. I don't think it's a one to two quarter resolution necessarily. But when we look at situations like this, clearly we want to see both expertise and capital come to bear on those assets. And as you see in our earnings deck, we feel that we're in a position to bring both of those as a fallback position to having attempted to work with the borrower. So timeline will be determined over the next 60 to 90 days. And I think when we chat with you all in 90 days, we'll have a more concrete plan there.

Great. Thank you. And as a final question, understanding that each asset is unique, but generally in your book, how have loss severities compared to your expectations, specifically for office and multifamily loans, and general commentary on what you're seeing in the market with respect to loss severities would be helpful as well.

I'll start it. Look, I think what we've attempted to do over the prior quarters has been to give our best estimate of where we expect to resolve assets and really limit surprises on these calls or dramatic changes in our outlook. And I think we've had some success doing that. As an industry, I would put forth that what's going on in the office sector has surprised many to the downside in terms of resolutions. That said, we've been as transparent as possible as we've worked through those. I think the lack of transparency generally in the market has probably delayed some resolutions throughout the broader space. And I think, as I said earlier, we're starting to see that crystallize to some degree with stability and rates. So I think over the coming quarters, you'll see more resolutions in keeping with expectations. Great. Thank you.

Our next question comes from Stephen Laws with Raymond James. Please go ahead.

Hi, good morning. At the risk of asking something you already mentioned, Brian, was a few minutes late, but, you know, can you talk about the non-accruals? I think it was, I believe it's 292 remaining. I know you guys made a lot of progress, but, you know, is there a a goal on a summer near-term resolution, summer longer-term, but maybe if you look to year-end, do you have, say, an idea of where you'd like to exit the year at that, on that number?

Yeah, thanks for the question, Stephen. I'll start, and I'll let Tasek chime in as well. Part of the challenge of the industry is measuring a lot of what we do by quarter, but certainly year-end is a good hallmark date to turn the page, so to speak, philosophically and financially. I think what we see is, especially with the offensive side of the market being so compelling, that while managing resolution price, we're going to balance that with resolution timing. So our conversations with borrowers are, If you were to go back what feels like a long time ago, three plus years, where extending duration of assets on the book was really the primary playbook, As we sit here today, we'd like to resolve assets and crystallize a lot of those resolutions and get back to the offensive side as soon as possible. So tough to put demarcation lines in terms of the calendar. However, certainly when we look forward to three quarters to year end, that's a pretty good place to plant a flag. But Tasek, feel free to add some color there.

Yeah, Brian, I think you covered it well. Steven, I mean, I think you probably heard from our opening remarks that resolving our underperforming loans, certainly including the non-accrual loans, is really one of our top, top, top priorities. We're hyper-focused on that effort. We think that'll bring a lot better clarity to our balance sheet as well as be accretive to our earnings, as we mentioned. But as Brian said, I think it's very difficult to provide precise numbers. We did resolve, as we mentioned, about four loans this past quarter, and we hope to continue to report some news on further resolutions in the quarters coming ahead.

Great. That was the main one I had today, so appreciate your comments this morning.

Thank you so much, Stephen.

Our next question will come from Steve Delaney with Citizens JMP. Please go ahead.

Good morning, Brian and Tasik. Busy quarter for you, and it sounds like it's continuing. With the four loans, non-accrual loans that you reworked, resolved in the first quarter, and then the two office REOs in the second quarter. I'm having a little trouble having a chance to go to the deck and just roll all this through. But after these second quarter REOs, can you tell us what is left at this point in five rated loans after the two REOs?

Uh, sure. I can, uh, Steve, I can try to take a shot at that. Yeah. So, you know, as we mentioned, uh, you know, there are eight loans that are risk rated four and five as of, um, you know, as a quarter end. Okay. Uh, and, and certainly it includes the two, uh, office properties that you mentioned, uh, that, that we anticipate, uh, going REO, um, in the future. You know, we also mentioned a new four-rated loan, a $97.5 million multifamily loan. And as we mentioned in our closing remarks, the reason it was downgraded from three to four is that the sale process of the underlying property, this multifamily property in Texas, you know, is just taking a bit longer than, you know, we had originally anticipated. And so because of that, it was downgraded. So that's really, call it three of the eight loans. Again, the two REO plus the one multifamily loan. And then when you really look at the remainder of the portfolio, what you have is you have some loans that have been kind of on our balance sheet for a while. We mentioned, for example, one of the mezzanine loans um you know that you know that we put on non-accrual and um just and then really it it is um you know the condominium development you know that we have um you know in new york and then it's the uh you know it's a large office loan out in illinois and it is an industrial asset out in california the $20 million loan out in California. So I think that covers, I'm just trying to recollect, are there others, but I think that makes up the remaining five loans that are in the four and five rate of loan category.

five loans as we sit today, less than four and five. And I understand this is fluid and things are going to be coming and going, but nice, nice to see some resolutions and some progress there. Brian, I know this is a decision the board goes through probably every month or every, you know, certainly every quarter, but the issue of, you know, your current 25 cent dividend and working to maintain that is, And the opportunity for share buybacks, you know, I would guess even with the loss of book value, you're still probably a little below 70% of book. How are you thinking about that, you know, in this market where everybody's having problems and, you know, you're looking at your stock, you know, with a mid-teens dividend yield? Just your thoughts, please, on that. how the company or shareholders are best served between paying out that cash or buying back your shares here. I didn't notice that you bought any shares in the first quarter. If I overlooked that, please let me know. Thank you.

Now, I appreciate the question, Stephen. As you said in your prior comment, the market is fairly fluid, and it is something that the board and management considers each quarter. As we characterized when we chatted 60, 90 days ago, what we established with the dividend at 25 was what we felt was attainable over the near to medium to long term, right? And I think that's something that we will continue to evaluate. And over the past 18 months, I think, we as an industry have contemplated the best way to serve our shareholders, and that is the combination of dividend, which is the core charge, I think, of the mortgage-rate business, as well as the relative value of buying back shares, which we've done previously. So, it's a balanced approach alongside managing liquidity and ultimately crystallizing the best returns possible for our investors. So, I would put forth that I think we'll continue to evaluate that in the coming quarters based on the results of that fluid market you mentioned. Got it.

Glad to hear that it's going to remain on the table regardless of, you know, and I know your board will make the right decision quarter by quarter. Thank you both for your comments. Thanks, Steve.

And once again, that is star one if you would like to ask a question. And our next question will come from Rick Shane with J.P. Morgan. Please go ahead.

Hey, guys. Thanks for taking my questions this morning. I apologize if some of this has been covered. First, as you sort of move from shrinking the balance sheet to moving back to offense, I'm curious if there are any covenants that you need to be aware of or any limitations related to your debt that could make that more challenging.

Yeah, Rick, thank you very much for your question and good morning. You know, as we mentioned in our, you know, in response to some of the prior questions, you know, we have been actively in dialogue with our lenders. And as you'll notice in our filing this morning in the queue, that we are starting to make some amendments to those facilities to make sure that we have the flexibility to implement the strategy that we talked about, right? So, if our strategy, as Brian mentioned, is to, you know, focus on resolving our underperforming loans, and in order to do that, we want to make sure we optimize the balance sheet to provide that flexibility. Deleveraging has been certainly a big part of that strategy, as well as maintaining, you know, good levels of liquidity. And so, you know, we continue to focus on those two elements. And then, again, we're proactively working with our lenders to make sure that The covenants and the loan facilities provide us that flexibility to attain the overall objective of resolving underperforming loans. So the answer to your question is yes, we are definitely proactively working with our lenders on this.

Got it. Yeah, I did a search of the queue for covenant and amendment, and I got 150 of each. So I wasn't able to find my answer. I'm sure it's in there. Second question, look, if we look at the forward curve and compare one month forward, so for 25 today versus where it was in January, expectations are rates are up 100 to 125 basis points from where expectations were in January. I am curious in your conversations with borrowers or what you're seeing if that expectation that rates are going to be so much higher for longer, and again, it's the forward curve, so we have to take it with a grain Is it driving people's behaviors to change in a material way from what sentiment was even at the beginning of this year?

Yeah, good question, Rick, and a few questions in there, and I'd say summarily yes. I think that the stability in rates in Q4 was catalytic in terms of causing some transactions to be consummated, and I think we saw a good pop of activity in Q1, much of which was in the headlines in terms of apartment industrial trades and fairly sizable ones. I think that the that started the process. Maybe capitulation isn't a perfect word, but for the real estate market to get back to forward-looking and to consummate transactions. While the rise in rates since that period of time has not been accretive to values, it's clearly in the public and private markets, you'll see a strong correlation to rates in terms of the prints. I do think that the the train started to leave the station to some degree. And therefore, we expect people to either realize that their assets are worth what they are worth and therefore move on. So, there's a financial capitulation, but also the time allocation for legacy holders of assets may no longer be worthwhile. And on the other side of that more positive tone would be that higher for longer means the yields available as a lender continue to be high. And widely publicized, when there is this level of duress in the market, it can be a generational opportunity to invest in equities, in structured debt, things like that. So, I think that the stability in rates and then the backing up is kind of either way going to lead to more resolutions, whether it's characterized as capitulation or great opportunities.

I appreciate that, Brian. Thank you so much, guys.

Appreciate it, Rick.

And with no further questions, I would like to turn the conference back to Brian Donahoe for any additional or closing remarks.

Appreciate that, operator. Yeah, I just want to thank everyone for their time today. We appreciate the continued support of ARIES Commercial Real Estate, and we look forward to speaking to you again on our next earnings call. Thank you.

And ladies and gentlemen, this concludes our conference for today. If you missed any portion of today's call, an archived replay of this conference will be available approximately one hour after the end of this call through June 9, 2024 to domestic callers by dialing 1-800-759-0728 and to international callers by dialing 1-402-220-7229. An archive replay will also be available on a webcast link located on the homepage of the Investor Resources section of our website.