Ares Commercial Real Estate Corporation (ACRE) Q3 2015 Earnings Report, Transcript and Summary

Good afternoon. And welcome to Ares Commercial Real Estate Corporation’s Conference Call to discuss the Company’s Third Quarter 2015 Earnings Results. All participants will be in listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded on November 5, 2015. I will now turn the call over to John Stilmar from ACRE’s Investor Relations.

Thank you, Gary. Good afternoon, everybody. We appreciate you all for joining us on our third quarter 2015 earnings conference call. Our speakers today will be Rob Rosen, our Chairman and Interim Co-CEO; John Jardine, our President and Co-CEO; and Tae-Sik Yoon, our Chief Financial Officer. Before we begin, I want to remind everyone that comments made during the course of this conference call and webcast, and the accompanying documents contain forward-looking statements and 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, as well 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 any such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results. I will now turn the call over to Rob Rosen, our Chairman and Interim Co-CEO.

Thanks, John. I’d like to start off by highlighting our strong third quarter results. We are pleased to report that we generated third quarter net income of $9.4 million or $0.33 per share, representing continued strong progress toward achieving our annual earnings goal and well above our quarterly dividend. These results were driven by solid recurring earnings from our principal lending segment, as well as improving earnings from mortgage banking, which originated over $200 million in commitments and further benefited from a favorable mix of higher-earning products. While we continue to expect roughly equal contributions from all three of our mortgage banking product lines over longer periods, we enjoyed a greater contribution from our higher returning products this past quarter. Secondly, I wanted to provide an update on our financing and capital management activities. As many of you know, our $69 million convertible notes mature next month, and we expect to have sufficient available cash and liquidity to repay the convertible notes. Toward the end of the third quarter and throughout the fourth quarter, we have been conserving cash from loan repayments to ensure certainty of repayment. Looking forward, we’re committed to growing shareholder value and accordingly, we continue to explore a range of debt financing alternatives to fund incremental growth. Consistent with our previous comments, we are currently only seeking debt financing options that are not linked to any equity issuance. Our balance sheet has deleveraged to the point where we now have additional capacity for incremental debt capital, as Tae-Sik will discuss a little later in the call. Before I turn the call over to John Jardine, let me update everyone on our earnings guidance for the remainder of 2015. As you may recall, we have raised our annual earnings guidance range twice this year from our initial range of $1.02 to $1.14 per share, to our most recent range of $1.12 to $1.18 per share. We are pleased to say that our business is performing well and we remain on track to achieve our latest guidance range of $1.12 to $1.18 per share. I will now turn the call over to John to discuss current market conditions.

Thank you, Rob. And good afternoon to all. We’re beginning to see the improving investment environment. The recent capital markets volatility is driving borrowers to adjust their expectations for the cost of certain types of financing. This is resulting in increased demand for shorter duration and often floating rate products, which directly benefits our deal flow. Since we are now seeing a higher cost of debt for fixed rate commercial real estate loans, borrowers are shifting to shorter term loans that carry a lower overall cost. This shift in demand is improving our deal flow and our ability to be even more selective about properties and sponsors. Pricing is also beginning to improve with modest spread widening in the fourth quarter compared to the end of the second quarter. And we expect this trend to continue as new issue CMBS spreads continue to linger at or near year-to-date wide spreads. While these capital market trends don’t explicitly impact providers like banks or insurance companies, we believe that insurance companies are near their annual allocations of capital for real estate debt, which is influencing current competitive dynamics. In addition, the permanent loss of GE in the marketplace has also improved the competitive landscape. GE was a major participant that originated about $5 billion to $7 billion annually with a highly competitive cost of capital. Now, let me touch on a few market developments in our mortgage banking segment. Given recent market volatility, I believe the importance of being able to offer stable sources of financing has increased and is further differentiating our business model from other capital providers. Our product offering continues to be diversified, which is also attractive to our borrowers. As many of you already know, we have a third and important product in our FHA business. The FHA business is not subject to lending caps and it continues to be an incremental source of earnings for our platform, particularly this past quarter. When looking at the full year 2015, we believe our product mix will end up being fairly balanced between Fannie, Freddie Mac, and FHA products. With respect to the GSE lending caps, it appears that the enhancements to the lending caps in 2015 may remain in place for 2016. We continue to expect that both GSEs are effectively managing their business towards their $30 billion cap, and will each end 2015 with total production of approximately $40 billion, including loans outside their respective caps. At this size, this continues to be a very attractive market for us with plenty of opportunity and room to expand production. Now, let me turn the call over to Tae-Sik to go through our quarter in more detail.

Great. Thank you, John. And good afternoon, everyone. Let me begin today with a recap of our third quarter results and then provide a summary of our loan portfolio, as well as our liquidity. Third quarter earnings was strong at $9.4 million or $0.33 per diluted common share, resulting in year-to-date earnings through September 30th of $25.4 million or $0.89 per diluted common share. This not only represents a 64% year-to-date increase in our earnings versus a comparable period in 2014 but more importantly, as Rob mentioned, these strong results position us well to meet our full year 2015 earnings goal. At quarter end, we also believe that we had a strong balance sheet, one that we can continue to position for earnings growth. On the asset side, we ended the quarter with 39 loans held for investment, totaling approximately $1.3 billion in commitments and $1.2 billion of outstanding principal, in both cases excluding non-controlling interest held by third parties. As we have mentioned previously, our loan portfolio has been purposely constructed as a short term floating rate senior mortgage oriented portfolio that is well-diversified by geography, property type, and borrowers. 83% of our loans, as measured by outstanding principal balance, are comprised of senior mortgages, collateralized primarily by multifamily apartments and office properties. 90% of our loans, again as measured by outstanding principal balance, our floating rate based on one month LIBOR. And our overall portfolio carries a weighted average remaining life of just over two years. 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 September 30th, 2015. On the liability side of our balance sheet, we ended the quarter with a debt-to-equity ratio of approximately 2.4 to 1. As we have discussed previously, our liabilities have been purposely constructed to match fund our assets. For example, I mentioned previously that 90% of our assets are floating rate, based on one month LIBOR. In comparison, 92% of our liabilities are also floating rate based on one month LIBOR. Due to this purposefully constructed match fund to capital structure, we are well-positioned for changes in interest rate. So for example, if one month LIBOR moves up, our net income would commensurately go up. We have also prudently managed the upcoming maturity of our $69 million convertible notes, which come due in mid December. As you may have noted in our earnings release this morning, we currently have approximately $70 million in liquidity and expect to have even more cash come through shortly in the form of loan repayments. These amounts will not only provide us capital to repay the $69 million in convertible notes but also some additional amounts to fund new loan originations. In addition, given our moderate debt-to-equity ratio at quarter-end of 2.4 to 1, we are working on a number of financing alternatives that we believe can provide us additional capital to fund future and new loan production. In terms of production for the third quarter, in our principal lending segment, we funded $37 million in new or existing loans and received $47 million in repayments as we remain disciplined on maintaining a highly liquid balance sheet ahead of our convertible note maturity. Turning now to our mortgage banking segment, which as we had noted previously, does not require significant balance sheet capital. We originated $207 million in new loans. This production was comprised of $45 million in Fannie Mae DUS loans, $23 million in Freddie Mac loans, and $139 million of FHA production. Earnings for our mortgage banking segment were approximately $3 million for the quarter, which again, positions ACRE well to achieve its earning goal for the year on a consolidated basis. Finally, before I turn the call back over to Rob, I just wanted to note that we declared a first quarter dividend of $0.25 per common share, payable on January 19, 2016 to shareholders of record on December 31, 2015. So with that, I will now turn the call back over to Rob for some closing remarks.

Thanks, Tae-Sik. I now want to close today’s call by highlighting our four goals that support our business plan for the remainder of 2015 and beyond. First, we are committed to growing the profitability of ACRE Capital. We believe our mortgage banking business continues to show progress and is beginning to achieve the types of ROEs we expect as evidenced by our double-digit annualized return this past quarter. Given the capital efficient nature and scalability of the business, combined with our broad product capability, we continue to be well-positioned for the future. Second, in our principal lending business, we will continue to focus on expanding our access to attractive growth debt capital, while maintaining our prudence to deliver attractive returns. We feel great about our long-term earnings potential, and current market dynamics appear to be improving and supportive. Third, we will continue to look for ways to manage our cost of capital. This will be aided by the retirement of our highest cost debt capital in December. And we are exploring a variety of new debt capital alternatives that we believe are more attractive. As part of managing the cost of capital, we will continue to weigh the opportunity to repurchase shares against investing in new loans, as appropriate. And fourth, we’re very focused on finding cost efficiencies to leverage our expenses. At ACRE Capital, for example, we are achieving significant economies of scale by leveraging our largely fixed expense base as production has increased. For the first nine months of 2015, ACRE Capital revenues have increased 54%, while expenses have increased only 4% over the same period. Our improved execution over the past four quarters has resulted in strong dividend coverage from earnings, four successive quarters of significant year-over-year earnings growth, and increases in shareholder equity. Our investment portfolio continues to perform exceptionally well. And we believe that we are well-positioned to benefit from any increases in interest rates going forward. I want to thank our employees for their hard work and dedication, and our investors for their support. We’d now be happy to take your questions. Operator?

[Operator Instructions] The first question comes from Steve DeLaney with JMP Securities. Please go ahead.

The hot topic for today seems to be ACRE Capital and I would like to pick up on that theme, if I may. Third quarter originations of $208 million, this to me, by my records, shows it’s the fourth straight quarter of at least $200 million. So, just looking ahead, if you were to put up total originations at ACRE Capital somewhere between $800 million and $900 million for the year, John, do you have any sense where that would rank you in the competitive landscape among the lenders out there, both Freddie, Fannie but also -- I know there’s a lot more HUD lenders, but I believe we’ve only got like 25 Fannie and Freddie lenders. Any sense what quartile $800 million or $900 million would put you in, from a marketplace standpoint?

We really look at it as a three-pronged platform. And so, we look at Freddie, Fannie, and the FHA. And that’s really the way we look at it. So, it’s hard for me to make that differentiation.

And I guess obviously we can’t include the HUD loans and where there’s so many lenders that we can’t really put the HUD lenders in there and then rank you within the GSEs, I get it. And even obviously it’s growing. Are you continuing to hire new lenders, new loan officers in ACRE Capital at this time?

We look at candidates on a weekly basis in various parts of the country. Yes.

And as you look at those opportunities one-by-one, obviously Alliant was an excellent acquisition, priced very well. Do you see other acquisition opportunities out there to basically acquire teams, whether they might even have some servicing along with the origination capability?

We look at every opportunity that can possibly present itself from individuals to teams and the like. So, we look at every potential opportunity that is presented to us.

This is Rob. I’d like to just add one point to John’s answer, and I’d like to just have you remember the significant investment that we’ve made over the past couple of years in our servicing platform, and the value that that brings to our ability to grow our mortgage banking activities. The quality of that platform, our ability to deliver consistent servicing capability across, not just the GSE platform, but our principal lending platform, is a very, very important part of the growing confidence that our clients and sponsors and counterparties have in ACRE. And that investment, the large and meaningful part of that investment is behind us. And now, we’re in a position to reap the benefits of scale.

Shifting to the other side on the principal lending, we have noticed a slowdown. And given the opportunities, John, as you described it, I have to interpret the slowdown, especially in the second and third quarter, as management planning -- kind of a planned slowdown, if you will, controlled lending in order to build liquidity to deal with the converts. So my question would be, once the converts are cleaned up in December, and if Tae-Sik and the team are able to find a new source of debt financing, do you see -- once that debt financing is in place, do you see a pickup in the principal lending portfolio from the $20 million to $30 million that we’ve seen in the last couple quarters?

Most definitely so. As I said in my prepared remarks, looking into the marketplace today, we see significant improvement in the environment, such that the demand for floating rate paper, adjustable paper right now is as significant as I’ve seen it in a while. So, we are poised and ready to take advantage of that.

And Steve, again, I really appreciate you expressing exactly our strategy the last couple of quarters. That’s exactly right. As we mentioned, we have absolutely been conserving cash that we’ve received primarily in the form of repayment to make sure and prudently that we have the liquidity to pay off convertible notes. And as you saw in our earnings release and as we said today that we have $70 million of liquidity. Obviously that’s sufficient to pay the $69 million of convert in the December. So that is de-risked and off the table. And we’re very happy we’ve achieved that milestone well in advance of the convertible note maturity itself. So that’s great news. As we also mentioned, we are looking at a number of debt financing alternatives for the balance sheet that as of September 30th is 2.4 to 1. We believe we have a lot of balance sheet strength to be able to achieve more debt financing, going forward. And that’s absolutely right, as you phrased it. That will be new capital that we will use to fund new originations going into 2016.

I appreciate everybody’s comments. And congratulations on the steady progress that you’re making here. Thanks.

The next question comes from Dan Altscher with FBR. Please go ahead.

I just want to follow up quickly on Steve’s last question around conserving cash. And I think in the prepared remarks, you also talked about getting some capital back in addition. So, can you give a sense of how much I guess in repayments or net capital, if you will, you expect to maybe see in the fourth quarter to build up in addition to the $70 million?

So, as you know, our portfolio, we’ve always focused on a very short maturity weighted average life portfolio. As I mentioned in fact, the weighted average life of all of our loans is just over two years. So, as you can imagine, every quarter every year, there’s a lot of movement and repayment of our portfolio, in addition to even prepayment. So, we do expect for the rest of 2015 for example that there to be approximately $20 million to $40 million of additional cash coming through in the form of investable capital. Obviously, if we lever that as we normally do, 2 to 1, 3 to 1, that provides in excess of $100 million of new loan origination capability in terms of senior loans. Again, that’s not counting on additional prepayment; that’s not counting upon any new debt capital we raise, but just what we anticipate based upon repayments coming up for the next couple of weeks here.

Perfect, okay. That’s a great answer to the question. I want to talk a little about what the fourth quarter guidance implies. And it seems like the major delta, as has been in the past and probably will continue to be is what happens in ACRE Cap. And I think trying to parse between what you’re all saying in terms of expectations for a kind of even mix of product; is the right read that fourth quarter margins are supposed to be -- or probably are more normalized versus third quarter as opposed to being volume-driven per se or a slowdown in volume driving kind of like the lower implied sequential quarter?

We have very much been focused on annual guidance, annual targets. One thing that is probably part of the more difficult part of our business to predict and control is the exact timing of when loans close, exactly when loans rate lock. So, as you can imagine, to us operationally, the production team in the field, they’re somewhat indifferent to whether a loan rate locks on September 30th as opposed to October 1st or vice versa. And all of us like to think of our earnings quarterly, but we really operate our business annually. And in terms of timing, it makes a big difference, given the size of our Company, given the scale of our production. For example, one $20 million loan or one $30 million loan can make a somewhat meaningful difference in what our third quarter results look like versus fourth quarter. So, we really would encourage the market, and we really think of it internally as are we out there achieving our annual production goals; are we out there meeting our annual earnings goals? And we really measure ourselves and our earnings on that annual basis. So, you are right. Mathematically, I think it’s easy to do sort of where fourth quarter is looking. But I think we would again encourage everyone to really think about our earnings on an annual basis.

I would add one more point. There are significant competitors who are giants in terms of their size and that’s not who we are. We are essentially a credit-driven culture seeking the best risk adjusted returns across the asset classes in which we play. And as Tae-Sik likes to say, we’re a bespoke lender who has grown consistently over the past four quarters, building our mortgage banking activity. And as we expect with additional capital to deploy in principal lending, we’ll be generating growth from that as well. But while we are the size that we are, the sort of combination of quarters is something that is going to have a little bit of fluidity. And that’s why I reiterate and really encourage everybody in assessing our performance to look at us on an annual basis. And I think you’ll find that we’ll be quite successful.

And then one other one, kind of just big picture, and I think John, you mentioned that I guess this environment right now, I think it’s kind of-- use your words, is probably as significant improved and that there is a significant demand for short duration floating paper. But do you think the environment has improved from a credit standpoint or stable or has the market may be adjusted from a spread or a yield component to factor in maybe some sense of heightened risk?

I look at the markets on a local basis, and I look at each product and each market locally. And as you know, we have offices throughout the United States, which helps boots on the ground, which helps us discern the appropriate investments that we make. So, at the end of the day, I look at the market and I say, there are certain parts, certain areas where I think there are added risks, and then there are other parts of the country where I don’t see -- I see a fairly stable and strong market. So, it’s a local business. I think our Group is positioned well to take advantage of opportunities in these good solid markets with good solid sponsorship. And again, the most important part of lending in these types of environments is to associate yourself with the highest quality individuals with the strongest business plan, because we are value add lender. And those people -- and their expertise is significant to this process. So, we are such a strong credit driven shop that we look not only to the real estate, but we look very, very closely at the skill and the professional expertise of the sponsors involved.

The next question comes from Jade Rahmani with KBW. Please go ahead.

Just on the 4Q guidance, can you point to any specific factors that are driving a sequential downtick in earnings?

Jade, I think we don’t look it as a quarter-to-quarter downtick in earnings. I think we have been very careful about explaining to the market what our annual earnings goals have been throughout the year. I think we are very, very much on track as we talked about in reaffirming those annual guidance goals. I do think there is going to be quarter-to-quarter variance in terms of what our results look like. Just because of the timing as we mentioned of when loans close, when loans pay off, when loans rate lock, when you have certain events happen. And again as I mentioned just as an example whether something happens September 30th or October 1st, as you can imagine from an operational standpoint, makes little to no difference to the people on the field, the people actually making the loans our staff, our team members working on these loans. So, while there may be variances, as we mentioned, between quarter-to-quarter, what we would again encourage everyone to do is really focus on are we achieving our objectives, are we operating the business, and are we meeting our earnings goals for the year as a whole.

But it’s not an overly seasonal business. And so with respect to ACRE Capital, it’s booking earnings based on rate locks. So, it seems to me either you are baking in conservatism about what the rest of the year looks like in terms of originations at ACRE Capital or there is some kind of cash drag and some uncertainty with respect to timing of closings on the -- timings of closing and repayments on the principal lending side. Is that correct?

Yes, I think you are well-deserving in citing some examples of what drives earnings for any quarter. Like you said, I think the timing of rate locks has a big impact on what exactly quarter earnings look like. The mix of what that product looks like for the quarter as well. As you know, our principal lending business segment is more recurring because it’s not as transaction driven, we have assets that go from quarter-to-quarter that remain on the books. But nonetheless, you still have new production as well as prepayments and payoffs. So there’s a lot of activities that go through it. Plus as you mentioned I think wisely that one of the impacts for the fourth quarter is simply holding cash that we are holding for the repayment of the $69 million convertible notes that come due. So again, I guess I would encourage you not to look at any one quarter, whether it’s a very, very successful quarter in your mind or a quarter that may be down quarter-to-quarter as exemplary of what future performance and what future prospects look like. Again, I really think it should be based upon have we performed throughout the year and are we meeting our objectives, are we beating our objectives, are we behind our objectives, but really focus less and less on quarter-to-quarter performance and more on year-to-year performance.

And then just on the interim co-CEO replacement, can you give any update on how that’s going and any timeframe that you might care to lay out?

I think I’ll speak for both of the co-CEOs, it’s going great. The sort of division of labor is, as we said, the business is being run on a day-to-day basis by John Jardine. I’m here sort of helping at both the strategy and the financing of the Company. I think that there is a fantastic collaborative attitude at senior management and down through the entire core of our organization. And, I couldn’t be happier with the way things have gone over the course of the last 12 weeks. John, anything to add?

Yes, I would agree. I think it’s been a very collaborative effort. And I think it’s worked quite well.

[Operator Instructions] The next question comes from Doug Harter with Credit Suisse. Please go ahead.

Hi. This is Sam Choe filling in for Doug Harter. Our questions have been answered. Thank you.

The next question comes from Thomas Shulkie, [ph] a private investor. Please go ahead.

You indicated you’re not looking at equity issuance at this time. Does that mean you’ve ruled out private preferred equity issuance also at this time? And just if you have any comments on possible use of preferred equity within ACRE; how you look at it?

I think that what we’ve consistently said is that given where we’re trading, in relationship to our book value and the quality of our book value, we currently have no intention of issuing equity or equity linked securities. I think you should expect that given our heritage at Ares that the examination of financing opportunities throughout the capital structure is something that we will always do. And we’ll seek to finance the Company with the best available sources of capital.

This concludes our question-and-answer session. I would like to turn the conference back over Rob Rosen for any closing remarks.

On behalf of ACRE and its management team and all of our employees, we thank you for joining, thank you for your interest. And we look forward to being in touch with you next quarter. Thanks again.