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Operator
Good afternoon, ladies and gentlemen. Welcome to ARIES Commercial Real Estate Corporation's second quarter earnings conference call. At this time, all participants are in a listen-only mode. And as a reminder, this conference has been recorded on Tuesday, August 6th, 2024. I will now turn the call over to Mr. John Stillmar, partner of Public Markets Investor Relations. Mr. Stillmar, please go ahead.
Stillmar
Good afternoon, and thank you for joining us on today's conference call. In addition to our press release and the 10Q that we filed with the SEC, we've put an earnings presentation under the investor resources section of our website at www.arecere.com. Before we begin, I want to remind everyone that comments made during the course of this conference call, as well as webcasts and 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. These statements are not guarantees of future performance, condition, or results and 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 filings, Aries Commercial Real Estate Corporation assumes no obligation to update any such forward-looking statements. During this conference call, we'll refer to certain non-GAAP financial measures. We use these as measures of operating performance and measures should not be considered in isolation from or to substitute for measures prepared in accordance with the 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?
Brian Donahoe
Thank you, John, and good afternoon, everyone. Before we begin a review of our second quarter 2024 results, I wanted to take a moment to congratulate Tasek Yoon as our new Chief Operating Officer and Jeff Gonzalez as our new Chief Financial Officer and Treasurer. Both of these appointments will be effective as of August 30, 2024. As you know, both Tasek and Jeff have been long-term members of our management team, with Tasek having joined in 2012 and Jeff in 2013. Tasek will continue to help execute our strategic goals, partnering with our debt capital markets team to further bolster the strength of our balance sheet and working with our asset management team. During the past 11 years, Jeff has worked closely with Tasek and our senior management team to serving in various finance roles, including as our controller since 2015. Jeff's financial expertise, long tenure at Acre, and deep understanding of our company and portfolio are highly valuable and make Jeff a natural choice as our next CFO. So with that, let me give some brief comments on market conditions and how we believe these trends are impacting our financial results and positioning of our balance sheets. Commercial real estate market sentiment is modestly improving, driven by reduced interest rate expectations, future supply dynamics, and the amount of capital available to be invested from the sidelines. While these positive dynamics are pointing to increased activity levels and a potential bottoming of CRE values more broadly, sales activities and financing of properties remains dynamic. These trends are impacting the timing of exits and resolutions, which, in turn, informs our strategy and impacts our near-term earnings. As one example, during the second quarter, the anticipated sale of a multifamily property securing one of our senior loans did not move forward as anticipated. Given the uncertainty around the ultimate execution in the sales process, we put the loan on non-accrual and revised the risk rating from a 4 to a 5. However, subsequent to the end of the second quarter, the property has since gone under contract for sale with a hard deposit, increasing the likelihood of a near-term resolution. Due to this variability in the market, our strategy is to maintain significant levels of liquidity and to further reduce leverage. Our focus on strengthening our balance sheet in order to drive maximum flexibility in addressing our underperforming loans results in uneven and below potential levels of earnings. Upon resolution of these loans, we expect the company will be positioned to invest further and return to a higher level of profitability. During the second quarter, we saw no negative migration in our risk-rated one-to-three loans. These 35 loans account for about three-quarters of our total $2 billion loan portfolio. Furthermore, the underlying borrowers have committed approximately $140 million of capital over the last 12 months in support of the risk-rated three or better loans. Now turning to our risk-rated four and five loans, we ended the second quarter with seven loans totaling approximately $477 million of outstanding principal. In the second quarter, we took title to a California office property that was previously financed by a $33 million risk-rated five loan and was on non-accrual at March 31st, 2024. In conjunction with this, we recorded a realized loss of $16 million and classified the property as REO held for sale. Also, during the second quarter, three loans migrated from a risk rating of four to a risk rating of five. These loans are comprised of the multifamily loan I mentioned earlier, one $69 million office loan in North Carolina, and one $20 million senior loan in California. We are focused on addressing all three of these loans, which would significantly reduce the balance of risk-rated four and five loans. With that, I'll turn the call over to Tasik, who will provide more details on our second quarter earnings and capital position.
Jeff
Thank you, Brian. I, too, want to take a moment and congratulate Jeff Gonzalez as our new CFO. Jeff and I have worked together for many years and look forward to our continued partnership. For the second quarter of 2024, We reported a gap net loss of approximately 6.1 million or 11 cents per common share. Our distributable earnings loss for the second quarter of 2024 was approximately 6.6 million or 12 cents per common share and was driven by a realized loss of 16.4 million or 30 cents per common share upon taking title to the California office property as REO that Brian mentioned. Distributable earnings excluding the realized loss of $16.4 million were $9.8 million or $0.18 for common share for the second quarter. Our overall CECL reserve now stands at approximately $139 million, about $2 million less than the approximately $141 million reserve as of March 31st, 2024. This reduction was driven by a $15 million reversal of an existing reserve associated with the realization of loss that was incurred on the California office property. The overall CSER reserve of approximately $139 million at quarter end represents about 7% of the outstanding principal balance of our loans held for investment. 90% of our total CESA reserve, or around $125 million, relates to our risk-rated four or five loans, representing approximately 26% of the $477 million in outstanding principal balance of risk-rated four and five loans held for investment. As Brian mentioned, we continue to take appropriate steps with our balance sheet to maintain financial flexibility in order to support our strategic priorities. We believe that operating at lower leverage and maintaining higher levels of liquidity in the near term best positions a company to maximize resolutions of underperforming loans and advance the long-term objectives of our company. Finally, we declared a regular cash dividend of 25 cents per common share for the third quarter of 2024. The third quarter dividend will be payable on October 15th, 2024 to common stockholders of record as of September 30th, 2024. And with that, I will turn the call back over to Brian for some closing remarks.
Brian Donahoe
Thanks, Tasek. As we've discussed, we are intently focused on executing on the goals of reducing our risk-rated four and five loans, which we believe will ultimately lead to the resumption of new investment activity, portfolio growth, and a higher state of profitability. In the near term, we're taking what we believe are the necessary steps towards bringing further certainty to the ACRE portfolio and book value. As always, we appreciate you joining our call today, and we'd be happy to open the line for questions.
Operator
Thank you, Mr. Donahoe. Ladies and gentlemen, at this time, if you would like to ask a question, please press star 1 on your telephone. And if you would like to withdraw your question, simply press star 2. We'll go first this afternoon to Shane Rick of J.P. Morgan.
Shane Rick
Wow, I don't know who that is, but we'll give this a try. Good morning, everybody. Hey, Rick. How are you? I guess I've been called worse. Anyway... Look, you know, and this is a question we've been asking to some of your peers as well. Conditions are changing very quickly. Outlook has changed radically just based upon the shape of the forward curve. Some of what dictates behavior is obviously fundamental, but a lot of it is sentiment-driven. How quickly are you seeing change? behavior from borrowers change, their outlook changing, their willingness to work with you, resolve loans, and, you know, try to hold on to properties just given the better expectations in terms of the forward curve?
Brian Donahoe
Yeah, it's a great question, Rick, and I think the optimism is starting to crystallize with rates, but you really started to see that creep back into the market beginning in around the holidays last year in Q4. And if you listen to the Aries management investor presentation, I think we noted about 2x the real estate activity year-over-year increase. And I think that's reflective of some of that change in sentiment. And the rate movement, certainly, I mean, we had pretty volatile markets over the last week, all of which may inert to the benefit of real estate values with the backdrop that we touched on in the prepared remarks of declining cost of funds and cost of capital alongside a supply story that starts to be more accretive to long-term values. So I don't know that the last month or so of rate decline has yet fully crystallized in terms of the market, but the sentiment is out there and the behaviors are changing in real time. And I think should all move directionally positive.
Shane Rick
Got it. Yeah, I appreciate that. Thank you very much.
Operator
Thanks, Rick. Thank you. We go next now to Stephen Law of Raymond James.
Stephen Law
Hi, good afternoon. First, I kind of want to think about, you know, it sounds like the portfolio is probably going to continue to run off a little bit and leverage it down, but that may or may not mean earnings go the same way. So as I think about when distributable earnings X losses are going to trough, you know can you talk about the the things that will move the needle there whether it's the financing or non-accrual assets uh potentially you know new loans to help facilitate a resolution um you know kind of how do we think about the earnings trough uh you know even given a declining portfolio size sure uh thanks very much for your question steven um yeah that's a great question in terms of you know what are the drivers of our current earnings
Jeff
Certainly, as Brian mentioned and as we have mentioned in our remarks for this call and in prior calls, we've been very purposeful in maintaining financial flexibility. We've been very purposeful in de-levering the balance sheet. We've been very purposeful in making our overall asset size smaller as well as maintaining higher levels of liquidity. All of that has obviously had its impact on earnings. The other thing that has had a big impact on earnings are the number of loans that we put on non-accrual, including, for example, putting on non-accrual this $97.5 million multifamily loan that Brian mentioned in our call. Each of those activities obviously has a big movement in our earnings, but as we said, as we continue to resolve these four and five risk-related loans, and we're able to either pay down debt associated with those assets, and many of those assets are in non-accrual. You know, we're not recognizing interest income from those. But as we resolve these risk-rated four and five loans and we pay down debt, we potentially utilize that cash for other purposes. Again, I think that can start to have a positive impact on earnings. I think one of the things that Brian mentioned is that we do expect to have uneven earnings as we work through our strategic plan. Our current earnings, as Brian also mentioned, are below potential levels of earnings. So your question is a great one. I do think there's a lot of different things that are going to move the earnings. And we're hopeful that as we resolve these loans and get Acre back into the business of investing in new loans and earning that interest margin, that we will be able to stabilize and increase our earnings on a go-forward basis.
Stephen Law
Great. And to follow up on that, you know, the current – you know, you've declared the dividend for Q3, and the current run rate annualized is about a 9.5% return on book value. You know, are you still comfortable with that as you look at longer-term earnings potential of the portfolio, you know, on a run rate earnings basis? Yeah.
Jeff
You know, I think, you know, our board declared the 25-cent dividend for the third quarter, and that was based upon – obviously, a review of our current financial position, our balance sheet, the outlook. But as we've said, we do think, again, we will have some unevenness in our earnings based upon the strategic activities that we're pursuing. As always, the markets will also impact our earnings going forward in terms of you know, the commercial real estate market in terms of interest rate, other macroeconomic factors. So I think our board will, you know, continue to evaluate our dividends on a quarter-by-quarter basis, take all of this into consideration. You know, as we've said, you know, we do believe that the market is, you know, variable right now, both in terms of certainty and timing. So we will, you know, we'll continue to evaluate our dividend, and the board will make these decisions on a quarter-by-quarter basis.
Stephen Law
Great. And then last question is for me regarding the new five-rated multifamily asset that went on a cool. I guess two parts. How much interest income did it contribute in Q2? And then, you know, assuming the sale that's under contract now, how much of a realized loss should we expect to flow through the third quarter of distributable earnings?
Jeff
Sure. So for the second quarter, you know, we did not recognize any income, any interest income from this multifamily loan. So it was on non-equal for the entirety of the second quarter. As you can see, sort of one indicator of, you know, but, you know, we did actually receive interest income again, but we did not recognize it as interest income. We did it as cost recovery. And so one of the things you can see is that the carrying value of this loan did go down from the outstanding principal balance to its carrying value by about $2 million. So that gives you an approximation of how much interest income was received but not recognized as revenue or income. And then in terms of the loss, we you know, potentially could recognize. I think if you look at our 10Q, you'll see that, you know, we have about a $6.5 million CISO reserve against this multifamily loan. Again, just given the sensitivity of it being under contract, I don't think we should be more specific. All of that happened, you know, post-quarter end. But as of 6-30, you can see we had about a $6.5 million CISO reserve against this multifamily loan. Great. Appreciate the comments today, Brian and Tasek.
Operator
Appreciate it.
Jeff
Great.
Operator
Thank you, Stephen. Thank you. We go next now to Jade Ramani at KBW.
Stephen
Hi. This is actually Jason Sapshon. I'm for Jade. What dollar value of REO do you ultimately expect, and where do you think book value per share might draw?
Brian Donahoe
Sorry. I had a tough time hearing the beginning of that question.
Stephen
Oh, yeah. I said, what dollar value of REO do you ultimately expect and where do you think book value per share might drop?
Brian Donahoe
So, if I understand the first part of the question, it's how much REO ultimately do you expect to see within the portfolio?
Stephen
Yes.
Brian Donahoe
I think it's tough to predict. Obviously, we have active dialogue with each of our borrowers and the primary charge of the company is to work through those discussions and to the extent that we're seeing value added by the sponsor, either operationally or financially, We'd like to keep everybody in their natural seat. There are situations where we do find that we as a large operator of real estate can add significant value in certain situations, and obviously those are times when we will step in to those assets, and I think that's an important factor. arrow available to us. So, it would be tough to put a finite point on the amount, but it's something that to the extent we do step in, you will likely see us do it for a short duration of time as we stabilize assets and return them to, I'll say, rightful ownership in the equity side of the ledger.
Stephen
Great. Thank you. And as a follow-up, what would drive migration from risk four to five in some loans, and are there any loans in particular that you're monitoring more closely?
Brian Donahoe
I'd say I'll let Tasek walk through some of the technical components of risk rating definition, but... Our asset management team is very well built out, and our monitoring is applied to every single asset in the portfolio, taking into account both financial results, borrower sentiment, interest rate, environment, and the like. All of the factors that would come through that viewpoint are taken into account as we think through those risk ratings. Maybe you can just give the five definitions.
Jeff
Again, I think that when you look through our public disclosures, you'll see some more definitive definitions of what maybe just to summarize and try to address your question of, you know, what would drive a four versus five, again, there's a multitude of factors, but some of the factors would include kind of the certainty and timing. So, for example, if you have a loan that doesn't mature for two years versus a loan that has already matured or has a very short-term maturity and You know, obviously the shorter-term maturity would increase the likelihood of a potential event, and that would be, you know, factored in, as well as, you know, the likelihood of a loss. So it's really a combination of a multitude of factors, but I would say, again, the timing and certainty of loss as that increases, you know, there's potential migration, therefore, from a 4 to a 5. Great. Thank you. Thank you.
Operator
We'll go next now to Doug Harder at UBS.
Doug Harder
Thanks. Hi. This is actually Will Maston for Doug today. I actually have a similar question on credit migration as the last one. I was hoping you could walk us through your confidence level and the current pace of credit migration, just looking at balancing resolutions versus development of new problem assets going forward.
Brian Donahoe
That's a good question. I think we touched on in our remarks in our first questionnaire around the overall market sentiment. If you look at the scale of our portfolio relative to the entire real estate industry, we're a very small portion of that. The positive sentiment is certainly the right backdrop, and a backdrop we're appreciative of having had a tumultuous 24-odd months here. You know, I think we're seeing stability in underlying fundamentals of the assets. I think as a catalyst, the change in rates is making it more likely for borrowers to continue to invest in their assets, just that change in the cost of funds. So as we touched on, no migration from the one to three assets and small migrations within the four and fives. and we're certainly focused on resolving those appropriately in the near term. So I think the backdrop is supportive of continued stability in the portfolio.
Operator
Okay, great. Thank you. Thank you. And just a reminder, ladies and gentlemen, Star 1, please, for any further questions today. We'll go next now to Chris Muller with Citizens J&P.
Chris
Hey, guys. Thanks for taking the questions, and congrats to Tasek and Jeff on the new roles. So I guess my question is, what would it take for you guys to get back on offense? Is it more working through some of the problem loans, or is it more Fed and sediment-driven? And do you think that could be a back half of the year type thing or more a 2025 type of that?
Brian Donahoe
Yeah, good question, Chris. I think ultimately we're – as you saw and as you heard, there remains some uncertainty out there, and the unevenness of the earnings profile is such that it keeps us thinking through, not out of the woods yet, but certainly starting to see additional light come through, and I think that stability I mentioned on the prior answer is a part of that. We've got a team that is at the ready to go on offense. We're seeing increased transaction activity broadly in the market. So we're excited by the prospects of getting back out there. But we want to make sure that we're doing so with sound footing. So the focus will remain on resolving those assets, bringing additional clarity to the book. And then we have a team that's, as I said, ready to go once we've brought that clarity to our stakeholders.
Chris
Got it. That's helpful. And then maybe staying on the asset management side of things, so of that $140 million of equity contributions from borrowers, I guess what is that going towards? Is it renewing rate caps, loan paydowns, reserve replenishments, or maybe a combination of all those?
Brian Donahoe
It's a combination. So think about, and I think part of the positive attributes of the movement in the interest rate curve is that some of that money is in the next iteration of it will be reallocated from carry and interest rate caps and be more to accretive spends like CapEx projects and tenant improvement dollars. So, as we've seen stability in even the office leasing market and slight upticks in the demand side there, those TI packages have gotten more expensive, so it is an important attribute that sponsors are continuing to invest in their assets. So it runs the gamut from carry to caps to renovation projects and certainly tenant improvement dollars that will be long-term value creators at the underlying asset level.
Chris
Got it. Thanks for taking the questions.
Operator
Absolutely. And gentlemen, it appears we have no further questions this afternoon. Mr. Donahoe, I'd like to turn things back to you for any closing comments.
Brian Donahoe
Thank you, and thanks, everybody, for joining today, and thank you to the entire team for all the work this quarter, and we look forward to speaking again in the near future. Thanks for the time.
Operator
Thank you, Mr. Donahoe. Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately one hour after the end of this call through September 6, 2024, to domestic callers by calling 1-800-756-8809 and to international callers by dialing 402-220-7214. An archived replay will also be available on a webcast link located on the homepage of the investor resources section of our website. Again, thanks for joining us, everyone. We wish you all a great day. Goodbye.
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