Good afternoon, and welcome to Ares Commercial Real Estate Corporation's conference call to discuss the company's second quarter 2015 earnings results. As a reminder, this conference call is being recorded on July 30, 2015. I will now turn the conference call over to Mr. John Stilmar, ACRE's Investor Relations.

Good afternoon, and thank you for joining us on ACRE's second quarter 2015 earnings conference call. On today's call, we have Todd Schuster, ACRE's President and CEO; and Tae-Sik Yoon, ACRE's Chief Financial Officer. In addition to our press release and 10-Q that we filed with the SEC, we have 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 and the accompanying documents contained forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the words such as anticipates, believes, expects, intends, will, should, may and similar such expressions. These forward-looking statements are based on management's current expectations of market conditions and management's judgment. These statements are not guarantees of future performance, conditions 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. Ares Commercial Real Estate Corporation assumes no obligation to update such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results. I'll now turn the call over to Todd Schuster, Acres' President and CEO. Todd?

Thank you, John. I am very pleased to report a strong second quarter for ACRE, in which our business generated net income of $9 million or $0.31 per share, representing a 35% year-over-year increase. These results were driven by combining strong recurring earnings from our principal lending business and improving earnings growth at ACRE Capital, our mortgage banking business. Based upon the broad-based strength of our business and our favorable outlook, we are increasing our 2015 annual earnings guidance from a range of $1.04 to $1.14 per share to a range of $1.12 to $1.18 per share. Importantly, much like 2014 set the stage for earnings growth in 2015, we believe that our actions in 2015 are positioning us for a continuation of the same in 2016 and beyond. I want to take a couple of minutes to highlight some of our more specific accomplishments in the second quarter. Starting with our principal lending business, we earned $6.8 million compared to $5.6 million in the second quarter of 2014, representing year-over-year growth of 21%. Moreover, we continue to find investment opportunities to further expand ROEs. For example, during the second quarter we closed a $39 million senior loan collateralized by a nationally flagged full-service hotel located in suburban New York. We expect this investment to be highly accretive with mid-teens returns before expenses. Furthermore, during the quarter we continue to execute on our goal of growing earnings with our existing capital base. Just a few weeks ago we completed the sale of one of our lowest yielding loan, a $75 million first mortgage collateralized by an office park in Southern California. We believe the sale of this loan at par and the subsequent reinvestment of the repatriated capital into new assets and the repurchase of our stock can generate 200 basis points to 400 basis points of incrementally higher ROEs. Moreover, our historical cost-based accounting does not reflect the value of our assets, particularly as spreads have tightened over the past few years. We believe that a sale of one of our lowest yielding assets at a 100% at par further substantiates this view and highlights the opportunity we see in our stock, given the discount of book valuation. Turning to our mortgage banking business. We earned $2.2 million in the quarter, reflecting a more favorable mix of higher margin products, and a 15% increase in volume, both relative to the prior quarter. While margins may fluctuate from quarter-to-quarter, we expect margins in the second half to be similar to the second quarter as opposed to the lower margins experienced in the first quarter. Lastly, I want to address our share repurchase program that we announced in May. We believe that our stock is trading well below its intrinsic value. And at today's levels, we believe that stock repurchases could be an accretive way to build book value and earnings. I will now turn the call over to Tae-Sik.

Thank you, Todd, and good afternoon, everybody. I'm going to begin today with a recap of our second quarter results, then summarize our loan portfolio and our liquidity, and then conclude with an update to our full year 2015 earnings guidance. We are very pleased to announce that our second quarter 2015 results was $9 million or $0.31 per diluted common share compared to $6.6 million or $0.23 per diluted common share for the same period a year ago. This represents a 35% increase in our earnings per share year-over-year. At quarter-end, we had a 41 loans held for investment, totaling $1.4 billion in commitments and $1.2 billion of outstanding principal, excluding non-controlling interest held by third-parties. All of our loans held for investment continue to perform in accordance with their terms and we have no delinquencies, defaults or impairments as of June 30, 2015. We also continue to match fund our assets and liabilities with respect to interest rates. Approximately 90% of our $1.2 billion in loans held for investment, as measured by outstanding principal, are floating rate. Meaning, that they earned interest based on one month LIBOR. This compares well to our liability structure, where approximately 93% is also comprised of floating rate debt. Due to our match-funding strategy, we believe that we are well-positioned to benefit in a rising interest rate environment, so that if LIBOR goes up, we expect our net income to go up as well. Turning now to our mortgage banking segment. We originated $233 million of new loans comprised of $90 million in Fannie Mae DUS loans, $100 million in Freddie Mac loans and $43 million of FHA production. As far as liquidity, as of July 29, 2015, we have approximately $63 million of cash or approved in undrawn capacity under our financing…

Thanks, Tae-Sik. Before I conclude with some remarks on our outlook, I want to briefly discuss some very exciting news that Ares announced last week. Last Thursday, Ares Management LP and Kayne Anderson Capital Advisors LP entered into a definitive merger agreement with the combined company to be named Ares Kayne, which will become one of the largest and most diversified alternative asset mangers with a combined $113 billion of assets under management as of March 31, 2015. The closing is anticipated to be on or around January 1, 2016, and will subject to various customary closing conditions. The combined firm will invest across five complementary market leading investment groups, which includes tradable credit, direct landing, energy, private equities and of course real estate. We believe that the combination of these industry-leading teams will make us all better investor, equipped with greater market knowledge, deal flow and capital access. In particular, we are excited about the prospect of having the real estate equity group of Kayne Anderson join our existing real estate team at Ares. They are experienced, high-quality group that we have come to know quite well, both by reputation and as an ACRE borrower in a transaction that we closed with them last year. We expect that their market knowledge and capabilities will enhance ACRE's market presence and provide opportunities to bring value to our shareholders. Before turning back to the operator, I want to address our plans for the business beyond 2015. During 2015, ACRE has delivered strong earnings as many of the seeds that we planted in 2014 are bearing fruit. Yet, as we look beyond 2015, we believe there are further opportunities for us to improve shareholder values by growing our earnings. And this part is important with our available capital. As such, we're focused…

[Operator Instructions] And our first question today comes from Steve DeLaney from JMP Securities.

I would like to start with the $75 million loan designated for sale in the quarter. I believe, I read a comment in the deck, not the press release, that it was one of your lower yielding loans and it looks like it was about LIBOR plus 375. I am just curious along this theme of enhancing earnings with existing capital, might we expect to see you do further culling of the portfolio moving forward? I noticed there is a retail loan as low as 325 over, so maybe just a little color on what your flexibility is to do more of those type of loan sales going forward?

So we're in the business of making loans and keeping them on the books and generating returns for shareholders for taking appropriate risk and getting paid hopefully disproportionably for those investments and for the risk we're taking. So the simple answer to your question is we are not looking to sell anymore assets. This was definitely, if not, our lowest, one of our lowest yielding assets that was also an asset of some size for us. And we definitely thought this particular asset presented us with an opportunity to repatriate some capital and we reinvest it at higher ROEs. And we also think it makes a really positive comment about the valuation of the assets on our book right now. So I don't think you're going to see anymore asset sales from us, but we think this one was important and did a lot of good things for us.

And it was, as you say, a little lumpy. And I guess having a more diversified, if you split that into three loans, you have got a move diversified credit book and maybe even more options on how to finance the new smaller loans?

And it freeze up capital for that and it freeze up capital to invest on our stock if we choose as well.

And you mentioned in the press release, additional strategies to enhance earnings. I take it that that's what you gave us your four point plan and that's what you were eluding to the in press release, those four points of execution?

That's right.

So Todd, the progress in ACRE Capital is pretty remarkable and you're now running it. I know, quarter-to-quarter it can be seasonal, but you're running somewhere $800 million to $900 million. Just as you see the business now and you see the kind of the tailwind, the FHFA has given to the multifamily market with these new exclusions from the caps, I mean could this business -- I mean, I'm trying to get a sense for the scalability from here. If we look out, say, 12 months from now, is it possible that the magnitude of growth there could be as much as a doubling of volume there given your platform and given the market opportunity?

So as you know, Steve, we don't give specific guidance around that, but I can tell you that I believe we're sort of still in the early stages of growth of that business. And I think that business has a lot of growth potential ahead of it. In some respect, we've only scratched the surface. In other respects, we've obviously made meaningful changes to the business, that are really adding value to the shareholders now. I expect that business to grow and grow significantly over the next two, three years. And I expect it to be in a position to not only grow its own earnings, but to be a significant generator of business for the balance sheet as well. And that was one of the reasons we did the transaction. And another reason was that we through it would be accretive from an ROE perspective and we are confident that that is the case. So again, I think we're in the early stages of continued growth for that business. And Fannie and Freddie obviously helped quite a bit, I mean the news around them and the caps and the relief fund to caps has been pretty meaningful, so all of that bodes well for the company.

So I think you probably maybe weren't aware of it when you made the acquisition, but it certainly has provided a huge point of differentiation between ACRE and some of the other commercial mortgage REITs that are strictly portfolio lenders. And then just one last little quick thing. So you're doing business with all three agencies and it was really nice to see the HUD volume given the profitability there, but other than ACRE Capital and Walker and Dunlop, do you know how many other lenders are actively engaged with all three agencies?

So we know there is about 24 or so Fannie Mae dust lenders and we know there is about 24 or so Freddie Mac lenders. And then within that, if you kind of look at who is active with both licensees, we think that number is 15 to 20, it's probably not quite 20, its probably closer to 15, but somewhere in that range. And then there is actually a lot of FHA licenses in the market, but very few people have kind of what I would characterize as vibrant FHA businesses. And so if you kind of layer that into the 15 to 20, it's probably a number of 10 or so maybe less that have kind of all three licenses and are very active with all three licenses.

And the next question comes from Dan Altscher from FBR.

Tae-Sik, you mentioned and then Todd, you both mentioned the convert coming up in the script and the potential to, I guess, refinance that maybe at a little bit more of an attractive rate of the all-in effective 9.4. Can you give us maybe a sense as to what you think that could look like if that's the route you choose to go down? And then, I know it's only going to be minor if it's only for like a month or two, but what plan is maybe incorporated into the new guidance or the revised guidance?

In terms of the convert, as you mention and as we mentioned, we're actually very excited about the opportunity refinance that form of debt. That was capital that we put in place more than 2.5 years ago, about eight months after we had completed our IPO, at a time when our shareholder equity was approximately $160 million. So we were much smaller nascent company with certainly a much smaller balance sheet. And the cost of capital at that time, I think reflected the somewhat growing stage of our business. So sort of apple-to-apple, here we are 2.5 years later, and our shareholder equity is $400 million, our balance sheet is $1.5 billion. So we do think, even if we are to replace it with similar type debt being a convertible note that we would shave a meaningful amount on the cost of capital. I don't want to give a pinpoint number, but we would estimate it to be certainly greater than a 100 basis points difference. But again, I want to make it very clear that right now given our share price, we would not be looking at a convertible note offering. And so the options that I mentioned previously at this time at this share price do not include a convertible note as one of the options, given again the fact that, we do not want offer common or equity links securities at today's share prices. Now, the options we are looking at would include other forms of debt financing as well as what we mentioned as given our current liquidity position, plus what we think is a very, a couple of upcoming maturities or prepayments of loans that we would have sufficient cash on hand to actually payoff the $69 million convertible note as well. So I think those are a little bit of more information on what we expect to do to payoff the convertible note, but I think given that it is our most expensive by a wide margin in terms of our cost of debt capital. I think this really represents a great opportunity for us to lower our overall cost of capital.

Todd, question for you. You mentioned the idea of a share buyback a couple of times in the script, and obviously, we know the repurchase authorization is in place. I guess, we didn't buyback any stock in the quarter which is fine, but how did you weigh that decision not to do that as opposed to deploying capital organically into the business. And if the stock price haven't moved up a little bit, is that still even an opportunity? I know you mentioned it is, but I would think you'd want to try to get stock lower maybe than where it is now?

It's an interesting question. So we weren't active in the buyback program in the past quarter. Part of that was just, I would say, tied to timing of when the program was put in place, certain restrictions around our ability to buyback stock. But let's not lose sight of the fact either that I mentioned a hotel investment, for example, that we made in the quarter. That's a mid-teens ROE. If those kinds of opportunities continue to be available to us, I mean, obviously we have to a take a long hard look at that. So the stock buyback is a real opportunity and option for us, we continue to evaluate it regularly against our capital availability and against our other investment opportunities. And we will continue to do that for sure.

And then just one other one I think also, Todd, in your remarks you mentioned how I think you think the overall product mix in ACRE Cap is going to be maybe relatively similar or at least the margin are going to be relatively similar, which is good to hear. But on the volume perspective I think you have often said that, fourth quarter, in particular, is a bit seasonally heavier than maybe a third quarter is. Do you think that's kind of still the right way to think about it this year, given that everything has been I guess maybe very, I don't know if accelerated is the right word, but has been very strong and constant throughout the entire year. Has it maybe been a little bit more front-end loaded than you might have thought?

It's a great question. My thoughts around that are that Q3 and I have been saying this for a few months now, that you could see a dip in GSE production specifically Fannie and Freddie sort of industry-wide, because of the way that sort of whole cap discussion is kind of working on people's pipeline. For us, we don't view it as a material issue, because in particular our FHA pipeline is so strong right now, and we've been saying that for while as well. So we like the prospects for our Q3, but I do think industry wide, you'll see the Fannie and Freddie numbers come in a little bit. I thank Q4 you could actually see meaningfully more production out of the GSEs for a variety of reasons. And so I think that's sort of how the rest of the year will play out. So Q4 in particular could be very strong. We'll get more clarity and visibility on that over the next couple of months, but I have every reason to believe that Q4 could be quite strong. And again, our Q3 I'm feeling very good about our Q3 just because the way our FHA pipeline has materialized over the last few months.

Our next question comes from Jade Rahmani from KBW.

Todd, I was wondering if you could give a view of the real estate cycle, the level of competition and if you're seeing any changes from how borrowers and sponsors are approaching the market given how strong pricing has been this year? And also you guys have an outsized concentration in multifamily and expertise in that space. So I was wondering if you could comment on that as well, as recently some equity REIT, prominent equity REITs have commented on supply increases in that market?

So let me take the second one first, Jade. And thanks for the question. So multifamily for us, we've been big believers in multifamily for a few years now. Part of that is evidenced by the amount of our balance sheet that has multifamily investments in it. We also obviously made a purchase of a mortgage banking business that was multifamily centric in the form of ACRE Cap a couple of years ago. So we have liked multifamily quite a bit. We continue to like numbers from multifamily. Yes, there are markets. We've said this for several months now, where there is some supply coming on. But if you look at sort of supply over the last few years, it has been very low. And we think the amount of supply coming on in general it's fairly rational. Yes, there might be a couple of markets where it might get a little ahead of itself, but as a general matter we think to supply for multi is as quite rational and we just think the demographic tailwinds is huge in that business from a demand side. And if you just look at, again, I mean everybody has quoted this statistic for a quite while now, but it is a very relevant statistic around the millennials and them coming of rental age, it's a big number. So there is a huge amount of demand. We think the supply is for the most part rational, and we continue to be very bullish on multifamily. Now, as a general matter, when you look at the cycle and where we are, if you view cap rate compression as low-hanging fruit, I think in general across the various products that maybe the low-hanging fruit is mostly gone, right. But I do think you're going to continue to see some modest increases and evaluations more from cash flow increases, occupancy is increases, rental rates going up. Those kinds of things, but not so much from cap rate compression anymore. You might see a little bit of cap rate compression in various asset types or in B and C quality assets right now, where people are chasing yield for the moment, but as a general matter, I think commercial real estate values, the increases in commercial real estate values that have come from cap rate compressions is significantly over at this point. And we're looking for value increases to come from cash flows and rents and occupancies.

CMBS prices have been pretty volatile. And I think there's notable spread widening late in the quarter. Did you see any spillover effects into the lending market and have you adjusted quotes you're providing on your loans?

So what we see in our main line business for the ACRE balance sheet isn't as sensitive to the CMBS market as you would expect. There is some sensitively, big movements will definitely push borrowers out of the CMBS market as they get, as their spreads widened and they think they're going into a financing at one spread and all of a sudden they're 30 or so wider. But as a general matter, we're not hypersensitive to that. So it hasn't had a meaningful impact on the spreads we're seeing in the market. As a general matter, the way we're set up with the direct origination system around the country, and we have really good market penetration. We're seeing a ton of flow, way more flow than we have capital for right now. And as result, our ROAs are holding up nicely. Again, if you look at the asset we did in Q2 that's a prime example, the returns on that asset are going to be very nice, very accretive. So we're not seeing a dramatic move one way or the other from CMBS spreads. In terms of when they were tightening, it didn't really affect our ROAs that much. And now that they've been widening, they haven't affected our ROAs that much.

In terms of originations mix for the principal lending business, are you expecting to allocate more toward mezzanine preferred equity given the stronger returns on equity that those loans provide?

Our subordinated debt portfolio has increased a little bit in size and it gets up to about 14% or 15% of the overall portfolio right now. I think the best way to think about it, Jade, is we're going to be opportunistic, some times sponsors come to us and they have just fabulous first mortgage financing and we don't want to sort of fight that, we want to embrace it. So we in effect use their financing as our financing and they will come in with some preferred equity overall and above that. Other time, there's a great opportunity to do a straight up first mortgage and we'll do that. So we're not looking aggressively to increase our preferred equity in mezzanine debt book, but we will opportunistically. If there are opportunities in the market to do, I don't have any problem letting that percentage breathe a little bit.

Jade, maybe just one other quick clarification. As Todd said, we're vey opportunistic about how we invest our in what form we invest. In terms of the return on equity ROE, I think we find that our returns on leveraging our senior loans versus the unlevered return on our preferred equity mezzanine are very comparable. And as Todd said, that's the analysis that we're always doing to see where are we getting the best risk adjust return, what type of financing is built into mezz structure versus what type of financing are we able to get if we do a senior loan. Those are all of the factors that Todd mentioned that we take into account, but overall, we find that ROEs on senior and the ROEs on the mezz preferred equity are very comparable.

And just finally on the dividend, given that earnings exceeded the dividend. And your guidance implies earnings in excess of the dividend, how do you view prospects for a dividend increase? And if there were some of the ACRE Capital earnings distributed as a dividend, would that portion of the dividend be taxed at the dividend tax rate since it's coming from TRS?

I'll handle the first part. And I think Tae-Sik will handle the second part of that question, Jade. As it relates to the sort of dividend and increasing the dividend, I love that we're having this conversation. I love that we're in a position to have this conversation. From our perspective, we look very carefully at a few things, but importantly we're looking at considering whether it make sense to increase the dividend in future quarters and/or increase book value, right. So we have the option, as you know, because the way the TRS structure works to retain earning, retain our capital and build book value. And so we're constantly kind of evaluating that. We think building book value is obviously a good thing for shareholders. We get that increase in the dividend is also a good thing for shareholders. And we're constantly trying to consider both of those things and balance it out. But ultimately, we would like to have the consistently growing dividend over time. I mean that is clearly a goal, one of our goals.

And Jade, maybe to respond to the second part of your question about the taxability of dividends from TRS up to REIT, as you know, the tax REIT subsidiary, as its name implies, itself is a tax paying entity. So taxable income is certainly taxable at the mortgage banking business, but unless until the TRS, taxable REIT subsidiary actually makes a dividend distribution to ACRE, the REIT, ACRE itself is shielded from the taxable income that is generated at the taxable REIT subsidiary. So as Todd alluded too, that gives us great flexibility in terms of retaining earnings within the TRS. And obviously, we are responsible for paying taxes at that level, but it does not cause ACRE to increase its taxable income. So it does give us that great flexibility to either dividend out more cash and/or retain cash and continue to build book value within the TRS.

Our next question comes from Rick Shane from JPMorgan.

A couple of questions. Can we start on capital. Does it make any sense to increase the dividend, given the discount to book value if you have earnings at the TRS? Doesn't it just make more sense to buyback stock?

Rick, I think that's exactly one of the options that we mentioned. Certainly, when we have cash, we have a number of options. We can invest it in new held for investment type of asset. We can increase our dividend or as you mentioned, we can buyback stock. And so I think one of the considerations that Todd mentioned that we are taking to account in term of either increasing our dividend or keeping our dividend is exactly that. We now have another tool available to us to further build book value to further build EPS, and buying back shares is certainly an available option to us for exactly the reasons you sited.

And then, I guess the follow-up to that is given the refinancing of the converts, will you be more cautious about buying back stock until you have absolute visibility on that, just in order to preserve liquidity and make sure that you can grow the left side of the balance sheet opportunistically if you choose to?

Rick, absolutely. In terms of managing our liquidity, managing our cash, managing our liabilities, we certainly have first and foremost the upcoming maturity of the convert. So if we thought the risk to repaying that debt was high, we certainly would make sure we conserve our cash in order to make that debt repayment. But we feel that we are well managing our cash right now. We feel very good about the upcoming maturity and our ability to repay it. So we believe we have a number of options available to us. But as you mentioned, our first and foremost priority of cash, for the next four or five months, will be to make sure that we have sufficient liquidity to pay back to convert. But as I mentioned, I think we feel very good about that. And that we have the options, we will have additional cash to purse other opportunities. I should also mention, I'm not sure if I fully responded to an early question from Dan about our earning guidance. Just to make clear that our earnings guidance, our increased earnings guidance does not take into account the fact that we would have to issue, for example, another convert to refinancing the existing convert. I didn't make that clear before. I just wanted to reiterate that assumption that goes into our earnings model with respect to our earnings guidance.

I mean it strikes me that you guys that what we're describing here is a low frequency, high severity risk, and it strikes me you guys are too conservative to take that on in the short-term. The other question -- I appreciate the guidance on gain on sale margin. As you guys know, within our models it's a very sensitive metric where we don't necessarily have a tremendous amount of visibility. So even just getting sort of a one quarter look really helps everybody tighten up their numbers. I'm curious what you think are the observable factors for us that we should be thinking about that influence gain on sale?

It's an interesting question. Well, first of all, the observable factor is, I think we made clear in our remarks that we actually think that Q2, Q3 and Q4 will be kind of consistent in the margins that we're going to generate in the business as compared to Q1, which was lower at a different product mix and a lower margin. We've also rate locked in this quarter about $62 million to date alone and the combined margin on those is equal to or maybe even higher than the margin that we have shown in for Q2. And so again that's supportive. I would say that one of the things that can impact margins is if you get volatility in interest rates. So interest rate vol can have an impact on margins. So if you really wanted to sort of kind of look for an indicator that would be one. But it's got to be pretty significant volatility. Rising rate in kind of very moderate way, not really that impactful, but it's the volatility, and we've talked about this in the past that can have a real impact on margins. So I hope that the answers your question.

No, it doesn't. Again, it underscores why that outlook for the next two quarters is so helpful to us. Thank you.

Yes. Thank you.

Our next question comes from Joel Houck from Wells Fargo.

I guess earlier in your prepared remarks, Todd, you made a comment regarding the accretion of the mortgage banking business relative to the principal lending. I'm wondering if you can put a little more color on that. It strikes me as ACRE is in a very unique situation, one that's not been in since it went public, and that is you don't really have to raise capital to grow earnings, other than just being cognizant of the restrain in terms of the size of the mortgage banking business and the TRS. So with that in mind, can you put any numbers in terms of a relative accretion of that business versus the more traditional principal lending segment?

So I'm not sure we'll put -- I'm not going to give you a specific number, but I'll give you a couple sort of just generic data points maybe. So there is obviously, we all know there is a pure play in this space, publicly held one that I know which is Walker Dunlop and their ROEs are probably mid-teens or so. So I think overtime for us to get those kinds of levels shouldn't -- that's a reasonable data point to look at. I can tell you that we are incredibly focused on building that business, on expanding, getting better all the time in that business, bringing in better and better producers, becoming more and more efficient. So I think there is still meaningful upside for us in that business. And we're very focused on growing it. In part because of the capital-like nature of it, but in part because we just see a tremendous opportunity in that space right now to grow it.

And is there any -- because you have the REIT TRS entity, they don't, is there any impediment to getting those types of returns, in terms of how big you can get? In other words, obviously there is a huge scale advantage. I'm just wondering how you guys have looked out and kind of thought about the returns relative to the size of how big the mortgage banking segment could actually be.

I think the balance sheet and one of the reasons if you think back to why we did the transaction to purchase ACRE Capital to begin with is, the balance sheet is actually a huge benefit to the business. The synergies that come with that are tremendous. There is a lot of people in the mortgage banking space, who would love to have a balance sheet, and don't. So the balance sheets a tremendous benefit. And the other thing that's interesting about our business maybe relative to some of our competitors is we have three primary products, two of them I would characterize as higher margin, one as kind of lower margin, right. And we're expecting sort of roughly a balanced production mix over the course of the year. So on that basis roughly two-thirds of our mix will be higher margin products. That's probably not typical for some of our bigger competitors. So that we actually have working for us, the scale of course is working against this a little bit, but overtime that's the upside, the scale is actually the upside for us.

And do you guys disclosed or mention at all like how capital is allocated between mortgage banking and principal lending?

Sure. I think we have indicated previously that the equity that we have in the mortgage banking business is really based upon, number one, the upfront cash purchase price and the stocks issued at the time we close the deal in the third quarter of 2013, plus some additional working capital dollars that we have funded the company. But it's just under 20%, it's an amount of capital that we have put in to the mortgage banking business.

Our next question comes from Ken Bruce from Bank of America Merrill Lynch.

I apologize, if this is redundant in any way. But can you maybe give us a little bit more of color around why you believe the gain on sale margins will be stable in the back half of the year? I know you tried to tackle that with Rick's question. But I guess I'm still a little left guessing, as to why you feel that they will be stable when I think most of us recognize that there is a bit of spread volatility in the market already and that has an impact on gain on sale.

It's a really good question. And look I think it has a lot to do with the product mix, right. So again, if you look at our first quarter, 60% of our business was in a lower, what I would characterize as a lower margin product. In Q2, 40% of our business was in what I would characterize as a lower margin product. And given the visibility we have on our pipeline going forward, we're pretty confident that the product mix is going to work to the benefit of the shareholders and to the benefit of margins relative to Q1. So that's really why we're saying it. It's really a statement about the product mix going forward.

So FHA, I assume, is essentially the driver of the higher margins versus the conventional?

Well, I'd say, again, we don't have, what we call, a conventional product in the mortgage banking business. We have FHA, Fannie Mae and Freddie Mac. We have said that FHA and Fannie are typically higher margin products, and it's all relative obviously, and that Freddie is a lower margin product. So we think we have good visibility on our FHA pipeline that has sort of a longer gestation period. So we've got some pretty good clarity on that. And we also think the Fannie Mae business is going to pick up towards the end of the year as well, and Freddie Mac will kind of hold pretty steady. I mean, that's kind of how we're thinking about the business right now. And it's pretty consistent by the way with what we've been saying for at least a quarter now. I mean nothing has really changed in that regard for at least a quarter.

Well, I guess it's nice to see the actual delivery of the higher margins in the quarter so that's helpful by itself. My next question, and I guess, when you think about capital structure you've addressed a lot of different questions just in your prepared remarks around how you're thinking about capital and the like. I guess the thing that always seems a bit self imposed is the leverage level that you're really talking about between 2x to 3x times. And I would just wonder is there a capacity to be able to take that higher should you see fit to so?

Sure, Ken. I think we look at leverage levels certainly on a consolidated basis, the way it's being reported to the shareholders and certainly the way it's being reported for debt compliance as well. But truly at the end of day, the way we optimize our leverage, if you want to call it that, is we really look at it loan-by-loan, deal-by-deal. So for example, if we have the opportunity to put a loan on a senior mortgage-backed by a very stable multifamily asset, I think we feel very comfortable going up to 4 to 1, maybe even higher. When we did our collateralized loan obligations and securitization transaction about a little less than a year, we actually achieved leverage better than 4 to 1 in that financing. And we thought that was a very attractive and appropriate level of debt-to-equity, because it was non-recourse, it was match-funded. It was, for a lack of better word, sort of permanent debt capital match funding the term of the anticipated underlying collateral. So when we have situations like that, we feel very comfortable going over 4 to 1 or even other sort of stated of level. In other situations, for example, when we have loans that are preferred equity or mezzanine positions, we have not directly financed those positions on a loan-by-loan basis. So again, I think we really tailor our leverage levels loan-by-loan or asset-by-asset. We certainly look at it on a consolidated basis. We certainly have covenants that we need to meet on a consolidated basis, which are significantly higher, that's really at the 4 to 1 on the consolidated basis with no more than 3 to 1 for a recourse debt, but again we really look at leverage on a deal-by-deal basis.

And then, I don't know, if this is disclosed anywhere, but what was your taxable income in the quarter?

Our taxable income if you look at the segment analysis, so our taxable income really, I mean, there is a tiny bit of income taxes for our principal lending business, but obviously it comes primarily from our mortgage banking business, which is held in the taxable REIT subsidiary. So if you look at the pre-tax income, it was $2.9 million, $2.938 million, the accrued income tax expense of $757,000, and therefore had net income after-tax of $2.181 million for the taxable REIT subsidiary.

I'm sorry. I guess I misstated that. So what would be, in terms of the REIT taxable income that would kind of derive the dividend?

Sorry, I misunderstood. Unfortunately, we have not disclosed. And again, we'd really calculate that on an annual basis, not quarter-to-quarter basis. There are a number of M1 adjustments from our GAAP income to our taxable income. So net income is a good directional view of taxable income, but it's not a precise view of taxable income.

Our next question comes from Doug Harter from Credit Suisse.

In your prepared remarks you talked about getting some expense leverage. I guess where would you say you are in that process and do you think there's room for more?

Sure. No, I think it's a great question and in efforts that we have had ongoing for several periods now. As Todd, mentioned there's certainly great examples of where we have already achieved some significant cost savings, professional fees being the example that you cited. So there is really what I call sort of two ways to benefit from potential expense savings, right. One is just the absolute reduction in costs. We have taken a very specific analysis and effort to make sure we look at everyone of our expense line items, whether it's insurance, whether its professional fees related to legal counsel, audit, any vendors we work with, we have looked at and continue to look at all of those line items Any out of pocket costs, any sort of consulting expenses, again, we have taken a very, very hard look at it with the eye towards, obviously, minimizing those expenses and making sure that every dollar we spend is to help increase our overall revenue and our overall ROE. So that's really what we call, sort of the first level. The second level is, as we continue to build out our balance sheet, we obviously have not grown our equity, but we have grown our assets overtime. And as we have done that, we will realize and continue to realize the fact that significant portion of our expenses are fixed, and so a good example that would be D&O insurance. As you can imagine, D&O insurance is a very expensive cost to us being a public company. All-in, it's approximately a $1 million a year for D&O insurance. The good news, if you want to call it that, with D&O insurance we expect is that even if we were to grow our company further, so if we grew revenues by 50%, if we grew assets by 50% and at some point hopefully we'll grow our equity by some percent, we would not expect D&O insurance to increase significantly. We certainly would not expect it to grow proportionally with our revenue, with our assets, with our equity. So that's really the second form expense savings through scale that we would expect going forward as well.

And ladies and gentlemen, at this time we will conclude our question-and-answer session. I'd like to turn the conference call back over to Todd Schuster for any closing comments. End of Q&A

Just want to thank everybody for being on the call today. We are obviously very proud of the quarter and are very excited about the future of the company. And we look forward to speaking with all of you soon about those exact things. Take care, everybody.

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 August 12, 2015, to domestic callers by dialing 877-344-7529 and to international callers by dialing 1-412-317-0088. For all replays, please reference conference number 10067139, an archived replay will be available on a webcast link located on the home page of the Investor Resources section of our website. Again, we thank you for attending. You may now disconnect your telephone lines.