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Ares Commercial Real Estate Corporation (NYSE:ACRE)

Q1 2014 Earnings Conference Call

May 7, 2014 11:00 am ET

Executives

Carl Drake - MD and Head - Public Investor Relations, Ares Management, LLC

John Bartling - Chairman

Todd Schuster - President & CEO

Tae-Sik Yoon - CFO

John Stilmar - IR

Analysts

Steve DeLaney - JMP Securities

Dan Altscher - FBR

Charles Nabhan - Wells Fargo Securities

Michael Rothenberg - Moab Partners

Jade Rahmani - KBW

Operator

Good morning and welcome to Ares Commercial Real Estate Corporation Conference Call to discuss the company’s First Quarter 2014 Earnings results. During today's presentation all callers will be pleased in listen-only mode. Following management prepared remarks the conference will be opened up for questions. As a reminder, this conference is being recorded on May 7, 2014.

I would now like to turn the call over to Carl Drake, Managing Director and Head of Public Investor Relations of Ares Management, LLC.

Carl Drake

Thank you, operator, and welcome, everyone, to our earnings call this morning. I am joined today by John Bartling, Chairman, Todd Schuster, President and CEO, Tae-Sik Yoon, Chief Financial Officer and John Stilmar from Investor Relations.

On this morning's call, we will reference our first quarter earnings slide presentation that can be accessed by going to our website at www.arescre.com. And by clicking on the Q1 2014 earnings presentation link on homepage of the Investor Resources section of the website.

As a reminder, comments made during the course of this conference call and webcast, and the accompanying documents may contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of the words such as anticipates, believes, expects, intends, will, should, may and similar expressions. We don't undertake to update our forward-looking statements unless required by law.

The company's actual results could differ materially from those expressed in the forward-looking statements for any reason 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 the past performance or market information is not a guarantee of future results.

I will now turn the call over to Todd Schuster.

Todd Schuster

Thanks, Carl, and good morning, everyone. I am really excited to report that we are on track to benefit from our recent capital and growth initiatives in both Principal Lending and in our Mortgage Banking and Servicing platform. The quarterly growth in principal lending's earnings from $2.9 million in the fourth quarter of 2013 to $5.3 million in the first quarter of 2014 demonstrates the earnings leverage we have gained from investing our available capital into attractive new investments.

The origination momentum in our principal lending business is continuing as showed on Slide 3 of our earnings presentation. During the first quarter, our new commitments increased 10% compared to the same period last year and this growth marked the fourth consecutive quarter of year-over-year growth in new commitments. In addition, Q1 was the first full quarter of investment activity under John Jardine's leadership. And as you may recall, John took over responsibility for our origination teams late in the fourth quarter of last year.

We are very pleased with the new direction and the expansion of origination capability and we fully expect our new investment momentum to carry into the second quarter. Also on this slide, you can see that our broad origination platform continues to find opportunities to produce generally stable ROA.

Staying on Slide 3, as of May 6, 2014, we expect to have about $58 million in available capital either cash or undrawn capacity under our funding facilities, and assuming we obtained financing for two recently originated senior loans. Assuming that we used such amount to make new investments and are able to achieve a debt equity ratio of 2.5 to 1, we should have the capacity to fund approximately $200 million of additional senior loan investments.

As we seek to further scale our balance sheet within principal lending, I want to knowledge that we believe we have access to alternative sources of leverageable capital that we believe would enable us to grow and be accretive to our earnings. Over the last three quarters, we have demonstrated our ability to access different forms of capital allowing us to continue to optimize our balance sheet. We have no current intention of pursuing a dilutive equity issuance at these levels.

It's worth reiterating that Ares Management is committed to the success of this company and in that regard we expect to continue to see strong support from Ares to its deal flow, relationship and resources.

Our cultured acre is centered on direct origination, routed in a philosophy of principal investing that leverages the broad credit capabilities and informational advantages that we believe exist across the organization. As we highlight on Slide 4, the shared focus at Acre and across Ares Management has let us to create an attractive, geographically diverse portfolio of more than $1.1 billion with 91% in senior secured loans and 95% of the loans tied to floating rates.

We have continued to scale our platform both in terms of resources and new sectors and geographies. We have been working with the Ares real estate team in Europe for the past several months identifying investment opportunities there. Ares Management is already a tenured and successful real estate equity investor on that part of the world with a 15-year track record of successful investing in Europe. Furthermore, Ares Management is one of the largest non-bank lenders to middle market companies across Europe through its direct lending platform based in the UK with three additional offices throughout Europe.

As a result, we believe expanding into real estate lending in Europe is a natural extension of our capabilities and by leveraging the scale and credit advantages that we believe are already embedded in these successful direct origination platforms.

Equally important to us is the strategic expansion into senior housing and healthcare. Similar to its deep investment experience in Europe, Ares Management possesses extensive healthcare investment experience across the platform. More specifically, Ares Management is an active investor in and lender to the healthcare industry through private equity and corporate lending activities.

Furthermore, given our strategic investment in ACRE Cap we have the ability to provide borrowers with both flexible bridge loans as well as long-term fixed rates government backed loans secured by multifamily and healthcare properties.

In order to leverage this broad-based capability, we recently hired a senior originator to build out our foot print in the healthcare real estate lending space. We expect to source new investments in both healthcare lending and the European markets later this year.

Supporting our growth is our ability to source attractive debt capital. On Slide 5, we highlight that as our assets have grown. We have worked with our banking partners, advisors and the rating agencies to attract diverse sources of efficient financing. To this end, in April, we accessed a highly attractive $195 million credit facility from UBS followed by a recent doubling of our funding facility capacity with Citibank to $250 million.

Tae-Sik will discuss this in more detail later in the call, but I think this slide underscores our progress in expanding and diversifying our sources of financing. And as we seek to grow our balance sheet, we intend to continue our emphasis on match funding our assets and liabilities. We believe our balance sheet is well-positioned for a potential in interest rates which we believe in turn enhances ROA.

Shipping focus to ACRE Capital, our mortgage banking and servicing business, please turn to Slide 6. We believe that ACRE Cap runs Acre's product offerings and access to proprietary deal flow and expand Acre's ability to drive outperformance in an increasingly competitive investment market. Given this opportunity, ACRE Cap has made strong progress in repositioning its origination capabilities with the hiring of 10 new originators since our acquisition of the business in the third quarter of 2013.

We are currently making progress on our strategic objectives including focusing on larger loan sizes as well as a growing pipeline of potential rate locked loans for the second quarter. In addition to the upgraded staffing and originations, we are actively working to improve and scale the servicing capabilities to meet the anticipated opportunities in that space. As ACRE Cap enhances the operating scale of the mortgage banking and servicing business, we also expect to experience better long-term cross selling opportunities and credit performance.

As noted last quarter, we expect the economic benefits of these changes to be more apparent in the second half of the year.

While ACRE Cap generated a slight loss this quarter as a company was rebuilding its origination capabilities, our success in hiring and the status of the pipeline gives us confidence that we will see enhanced earnings from ACRE Capital on the back half of this year.

In summary, we expect that our principal lending business will continue to improve its profitability as we continue to make new investments into an increasingly efficient capital structure. Moreover, we are excited about the expansion of our platform into several new and attractive segments where we can leverage the expertise of the Ares platform. Regarding ACRE Cap we are pleased with the building second quarter pipeline that we believe will put ACRE Cap materially ahead of first quarter production levels and on track with our expectations.

I will now turn the call over to Tae-Sik to discuss further advancements on our financing and more details surrounding our first quarter earnings.

Tae-Sik Yoon

Great. Thank you, Todd, and good morning, everybody. Today, I'm going to be discussing the financial result for the company for the first quarter of 2014 and, as Todd mentioned, discuss some of our recent accomplishments including most particularly the significant expansion of our borrowing capacity. So let me start off with our financial results this morning.

As Todd stated earlier, our consolidated net income for the first quarter of 2014 was $4.8 million or $0.17 per common share. That, as you saw in our earnings release this morning, represents a 45% quarter-over-quarter increase versus our results in the fourth quarter of 2013. This strong growth in net income is primarily attributable to the accretive impact of closing more than $500 million in loan commitments in the fourth quarter 2013 and the first quarter of 2014 in our principal lending business.

The $4.8 million in net income was composed of a $5.3 million gain in our principal lending business, which itself is up more than 80% quarter-over-quarter from the fourth quarter 2013, and a loss, as Todd mentioned, of about $576,000 in our mortgage banking segment versus a gain of $361,000 in the fourth quarter of 2013.

For the principal lending segment, we originated seven senior loans during the quarter, totaling $193 million in commitments of which $179 million was funded at closing. These amounts included six new loans totaling $146 million in commitments as well as a refinancing of an existing $47 million loan. So at quarter-end, at March 31, 2014, we had 39 loans totaling more than $1.2 billion in commitments and $1.1 billion of outstanding principal. And of course, all of the loans that we held continue to perform in accordance with their terms and we recognize no impairments at March 31, 2014.

Since ending the first quarter, we have closed an additional three senior loan so far into the second quarter totaling $77 million commitments of which $73 million has been funded so far. So this raises our principal lending portfolio now to 42 loans totaling nearly $1.2 billion in outstanding principal.

And as you heard earlier from Todd, subject to obtaining financing commitments in accordance with the terms of our existing funding facilities, we expect to have capacity to fund approximately $200 million of additional senior loans going forward.

Now shifting to our Mortgage Banking business, ACRE Capital rate logged approximately $28 million of Fannie Mae DUS and FHA HUD commitments in the first quarter. We continue to expect that our origination activity and, therefore, our fee income and accretion of new mortgage servicing rights will continue to ramp up throughout the remainder of 2014. We have added production teams and they are focused in closing new larger loans under GSE and FHA HUD programs.

Turning to our balance sheet, we continue to believe that we are well-positioned to benefit in a rising interest rate environment. As of March 31, 2014, approximately 95% of our principal lending portfolio is comprised of floating rate loans based on LIBOR. So if LIBOR rises, we expect that our unlevered effective yield will commensurately rise.

In addition, we have carefully crafter our liabilities to match-fund our assets. Each of our funding facilities, including our lines with Wells Fargo, UBS, Citibank, Cap1 along with our new City National Bank revolving facility and the commercial-mortgage backed securitization that we issued last fall, again, are all floating rate based on LIBOR. Only our $69 million convertible note issued back in December of 2012 is fixed rate.

So, overall, that means approximately 95% of our liabilities are floating rate, which, by design, matches our approximately 95% floating rate asset base.

Since we are well match-funded in terms of interest rate, similar to the impact that an increase in LIBOR would have on an unlevered effective yield, we expect that an increase in LIBOR would also result in an increase in our leveraged ROA.

In addition to carefully match-funding interest rate exposure, we have also continued to expand our borrowing capacity to fund a significant growth in our loan originations. Since the start of this year, we have added $370 million in new capacity. First, in March, we closed on a new $50 million revolving facility with City National Bank. Second, just a few weeks ago, we closed on a $195 million funding facility with UBS and, just yesterday, we successfully doubled the commitment under our existing Citibank facility which increased from a $125 million to $250 million. So with these two new facilities and an increase in the existing Citibank facility our total debt capacity is nearly $1.3 billion, including the $395 million commercial-mortgage backed securitization we closed in November.

Finally, with respect to dividends, our board declared a second quarter dividend of $0.25 per common share, which is consistent with our quarterly dividend level through 2013.

Now before turning the call back over to Todd, I wanted to note that our earnings release for this first quarter 2014 did not include reference to core earnings, an alternative measures that we have included in the past.

As you know, Acre originally adopted the definition of core earnings more than two years ago prior to our IPO when our business was focused solely on principal lending. However, following the acquisition of ACRE Capital in the second half of 2013, management believes that core earnings will become a less meaningful measure of ACRE's consolidated financial performance going forward. Accordingly, we have decided to discontinue the practice of reporting core earnings.

And with that, I will now turn the call back over to Todd for some closing remarks.

Todd Schuster

Thanks, Tae-Sik. Before we conclude, I wanted to update everyone on an exciting development involving the parent company of ACRE's Investment Adviser. Last week, Ares Management L.P. priced its initial public offering on the New York Stock Exchange. Following its IPO, Ares Management employees retained ownership of more than 70% of the company. We believe that this transaction is positive for the future of ACRE as the continued growth of Ares Management will enhance Ares Management's ability to attract and retain professional talent and strengthen the Ares platform and provide ACRE with a broader ray of information and services.

At ACRE, we continue to grow our core principal lending business. We have a leading commercial real estate direct lending platform in our sector which enables us to see a broad view of the market opportunity and to select strong risk adjusted returns. We are excited to further expand our platform in to several new geographies and markets by leveraging Ares deep expertise. We see tremendous opportunity over the longer term to scale this business in the U.S. and Europe as we take advantage of the changing bank regulatory environment and the compelling long-term opportunity to finance parts of business plans around transitional assets.

We are also very optimistic about our mortgage banking and servicing business as we are seeing origination momentum resulting from our repositioning efforts, which we believe will result in enhanced earnings in the back half of this year.

Taken together, we see great potential for these two complimentary businesses to drive shareholder value. In the near term, our objective is clearly to earn and or exceed our current quarterly dividend. We believe we remain on track to accomplish this objective in the second half of the year.

I would like to thank our shareholders for their support and our employees for their hard work and dedication.

And with that, operator, would you please open up the lines?

Question-and-Answer Session

Operator

(Operator Instructions).

Our first question comes from Steve DeLaney. Please go ahead.

Steve DeLaney - JMP Securities

Thank you. Good morning, everyone. Todd, as you look ahead to the second quarter, you have already closed three lines for $75 million. As you see the near term pipeline, are you comfortable giving us any indication as to whether the second quarter volume is likely to exceed 146 loans and $146 million, excluding the re-fi that you booked in 1Q?

Todd Schuster

Steve, what I can tell you is that we are seeing a lot of activity in the market right now. A lot of inquiry into us as it relates to financings across a broader array of asset types. The momentum is clearly building and we are very encouraged by what we are seeing right now.

Steve DeLaney - JMP Securities

Okay. I'll take that as a positive outlook. Thank you. And looking forward, I know Europe is going to take a while to come together. But when you see the market, does the loan products over there and the opportunities should we expect that the bulk of the debt you originated over there, over in Europe, U.K. or in the mainland would be senior floating rate type of structures as opposed to more mezz like opportunities? Just if you could comment more sort of from a loan product rather than just geography, what might we see there?

Todd Schuster

Yes. I would expect that we would continue our sort of protocol and methodology that we have employed here in the U.S. so that we would continue with direct origination, we would continue with the senior loan focus and we would continue with the floating rate focus.

Steve DeLaney - JMP Securities

Okay. Very good. And I noted that in the first quarter five of the six loans were multifamily. You've talked in the past about the synergy between your principal lending business and ACRE Cap. As you look at those relationships and the nature of those loans in terms of the transitional aspects, would you expect that some of those loans will end up being refinanced by ACRE Cap in the next two to three years?

Todd Schuster

Well, a couple of things. First, I mean we are seeing -- we continue to see a lot of inquiry around multifamily. I firmly believe that part of that has to do with the fact that we have matched up ACRE Cap with the balance sheet and we are seeing a lot of that synergy playing out right now. There's a lot of sort of cross dialog, cross inquiry, cross selling. So I think that multifamily continues to be an important part of what we are going to be doing over the next -- for the foreseeable future. But we also see great opportunities in other asset classics. We are seeing -- we continue to see office as an interesting opportunity and we are also exploring others as well. Did I get to your question?

Steve DeLaney - JMP Securities

Yes, I think so. I appreciate the comments. Thanks Todd.

Todd Schuster

Yes.

Operator

Our next question will come from Dan Altscher from FBR. Please go ahead.

Dan Altscher - FBR

Thanks. And appreciate you taking my question this morning. I was wondering on financing side, how does the outlook right now look for another potential CLO or securitization or I guess CMBS Securitization? Obviously, when you did the one earlier in the year, the loan book was right around $700 million that held the investments kind of trending right around that area. But again, what is appetite or outlook for doing that sort of a financing structure?

Todd Schuster

So it's a great question, thanks. Look, I think we are always, always, always evaluating the opportunities on the right side of the balance sheet. So we will continue to look at the CMBS market and CLO market to evaluate whether it’s the best execution for us. We are obviously very aware of what’s going on in those markets. We constantly monitor them, are constantly evaluating them. We haven't done one transaction last year where we are fully up to speed on what we can and can't do there. And while I can't necessarily comment on what are plans are, you can be sure that we are watching it carefully. And as we achieve a critical massing our portfolio; if there's an opportunity to do something then we'll take a hard look at it.

Dan Altscher - FBR

Okay. And they maybe just broadly of about the spread environment, just looking at the quarterly trend it looks like a spread or the overall asset yields continue in the drop a little bit. Can you talk about the competitive nature of the business right now? It certainly feels like confidence heating up across the senior part of the mortgage market. Are you guys have seen that too or there is may be some selective nature in what you're underwriting in terms of booking from perhaps a lower asset yields and reflective of the actual assets that you are looking to underwrite?

Todd Schuster

The way we compete is we compete with throughout direct origination system, we compete with flexible capital, we compete by being creative around structuring with sponsors. We compete because we're a reliable source of capital that closes when we say we're going to close.

So for all those reasons, I think if you look at the chart in the book -- in the dec that we attached, if you will, I think you would see that our ROAs are actually kind of holding up right now. And in addition, we are seeing, and you mentioned the CMBS market before, we are seeing a meaningful amount of spread compression on the securities side. So our ability to execute on the right side is increasingly getting better. And again our ROAs are holding up right now and it's mostly tied the way we approached the business and the value add we create for our clients.

Dan Altscher - FBR

Okay. If I can just maybe sneak in one numbers question for Tae-Sik, in ACRE Capital, the comp line moved up a little bit this quarter again. I don't remember if there was maybe some noise in the fourth quarter, but just want to see if there was noise in this quarter once again or if this maybe little bit more representative of the run rate now that you've maybe completed majority of the hirings?

Tae-Sik Yoon

Sure. Good morning, Dan. I appreciate the question. Yes, in terms of ACRE Capital we've obviously added some new personnel as we talked about in our prepared remarks. And substantial part of the increase that you saw from the compensation expense last quarter to the this quarter is $3.7 million to little bit over $4 million has to do with increased staffing as well as one-time cost associated with recruiting, signing bonuses, those kinds of things. So I wouldn't quite take the $4 million as the some sort of run rate, but you are correct in assuming that the increase was due to staffing levels that have been increasing as we continue to build up the team for ACRE Capital.

Todd Schuster

And let me just add, those staffing levels are all around productivity. So we've been hiring, as I mentioned before, some really high-quality loan producers for ACRE Cap and that in part is what you're saying in that line item.

Dan Altscher - FBR

All right. Thanks guys. Appreciate the time.

Tae-Sik Yoon

Sure. Absolutely, Dan, thank you.

Operator

Our next question will come from Charles Nabhan from Wells Fargo Securities. Please go ahead.

Charles Nabhan - Wells Fargo Securities

Good morning and thank you for taking my question. Within the principle lending business you had mentioned that you'd be looking at larger dollar loans among your initiatives. Now in the first quarter, let's say the average loan size is probably in the $20 million to $30 million range, and excluding the $200 million originations in the fourth quarter that $20 million to $30 million average stood. Now, going forward, how should we think about what loan sizes do you intend to target? And in terms of time frame how should we think about a potential migration towards larger dollar loans?

Todd Schuster

That’s a great question. I think what you're noticing in the last quarter is that we moved a little bit into some secondary markets but following our top high-quality sponsors in the some of the secondary markets where we see some opportunity and value. And when we do that, that’s likely to bring down the average loan sizes a little bit. As we stay in primary markets and finance sponsors in those markets those intend to be higher average loan sizes, but ultimately we're going to move to where the opportunities are and where we see the value is.

Charles Nabhan - Wells Fargo Securities

Okay. And a quick number's question, do you have the LTV on maybe the originations this quarter versus the existing book?

Todd Schuster

LTVs, I don't think this information that we typically provide.

Charles Nabhan - Wells Fargo Securities

Okay. I guess one more quick follow up with I guess my own question, when you think about the fundamentals of primary versus secondary markets, could you perhaps give us some color on what you're seeing in terms of rent, in terms of fundamentals, in terms of price recovery in those markets and where you are seeing opportunity?

Todd Schuster

Yes, first of all, you would expect that the increases in values have lagged what's gone on in sort of the primary especially the coastal market. There is a general improvement of the fundamentals across the secondary markets. Obviously, different markets have different technical and fundamental aspects to them, but as a general matter, we are trying to find those secondary markets and asset classes in those secondary markets, again, where the value is and we are trying to follow as opposed to sort of leading ourselves into the secondary markets we are trying to follow our good sponsors into those markets so that we are making sure that while we are in secondary markets were with the best folks in those markets.

Charles Nabhan - Wells Fargo Securities

Great. I appreciate the color guys. Thank you very much for your time.

Todd Schuster

Thank you.

Operator

Your next question will come from Michael Rothenberg from Moab Partners. Please go ahead.

Michael Rothenberg - Moab Partners

Hi, guys, thanks for taking my question. In your prepared remarks you talked about no interest in raising equity at this time and a desire to earn your dividend. I presume the first point because your stock is trading around 85% of book value. Can you get a little bit more -- I want to say also that we're very concerned because shareholders here we see a disconnect between management going into areas based on our asset sales and potential dilution of an equity offering. So I ask if you can get a little bit more granular on how you expect to earn your dividend. And you talked about upside in the back half of this year. You can maybe quantify certain things were missing and in the last quarterly report.

Tae-Sik Yoon

Sure. Good morning, Michael, thanks for your question. Yes, in terms of earning our dividend, I think it is important to note that one think we mentioned on our call this morning, our remarks this morning is that principal lending business alone, as you can see in our segment reporting, generated about $5.3 million of net income, which is obviously a significant increase from our prior quarter's income. And that really compare us to dividends on our current $0.25 of about $7.1 million. So that's about $1.08 million difference. So we are getting close and the momentum is certainly building for principal lending, as we discussed, to get to a higher number.

In addition, as we mentioned while there is a number of factors that could ultimately impact the outcome of our earnings, our goal continues to be that the dividend will be earned from our principal lending loan. And probably most importantly, as Todd said, when we really take the two businesses together so principal lending and mortgage banking, as you can tell mortgage banking so far is not a business that has generated the returns that we believe it will generate, but once we put the changes that we are putting in place now into place we believe that when we take the two businesses together that we will meet and even exceed the dividend over time, and particularly starting in second half of this year.

Michael Rothenberg - Moab Partners

And can you maybe get a little more specific on the mortgage banking side where the upside is versus the first quarter? Is it expenses or is it? Yes.

Tae-Sik Yoon

Yes, it's not so much expenses. I mean, obviously, as we mentioned, there will hopefully be some rationalization expenses once we get through our restructuring. So as any company once you are going through a restructuring phase you will incur some one-time expenses and we are starting to see some of those starting to come through in this quarter as well as in the upcoming couple of quarters. But really the upside, the question you asked, the upside comes from significantly greater production levels. This quarter in particular we generated $20 million of new loan production for the mortgage banking business. Obviously that is significantly below the historical numbers the company has produced even prior to us acquiring it, and our goal is significant increase that number, and that's where the upside. The upside is we could put in the new originators we talked about we are undergoing the restructuring changes we talked about and we expect all of that to result in significantly greater production level going forward, again, starting particularly in the second half of this year, and that's really the upside to the mortgage banking business. Todd, I don’t know if you want to (inaudible) --

Todd Schuster

Yes, I think that Tae-Sik I think that's all right. I would just add that we are actually starting to see the pipeline build for the second quarter as well. So we are seeing second quarter momentum in that business and we expect that to continue and accelerate into the third and fourth quarter.

Michael Rothenberg - Moab Partners

Okay. And on the origination side, can you maybe quantify if you had your current book in place for a full quarter, would the earnings be meaningfully higher or, because some of these loans obviously then enjoy the benefit all three months?

Tae-Sik Yoon

Yes, I mean, clearly if we were to originate higher loan levels, the earnings for the mortgage banking business would be higher. As you can tell, we booked even with $28 million of loans closing the rate locked in the first quarter of 2014 you can see our mortgage banking revenue was approximately $4.7 million. So as we continue to book more loans and greater volumes we would expect revenues to significantly increase. As we talked about in some of our prior quarter calls, we do have some fixed expenses and some variable expense; the single largest variable expense being really commissions. So there would be some commensurate increases in expenses along with revenues, but we would fully expect that as we increase originations that our net income for the mortgage banking business would increase.

Michael Rothenberg - Moab Partners

Okay. Got it. I was trying to get to the other side of the business. I guess maybe we are not seeing the benefit of the full quarter in the principal lending because some of the loans came way in the quarter.

Tae-Sik Yoon

Yes, that as well. So timing in the principal lending business does matter quite a bit. In fact, one of the things that we mentioned in the fourth quarter results is even though we had very significant originations in the fourth quarter, the fourth quarter, the vast majority of those loans really were closed in the last 15 days of the quarter. So those loans $359 million of originations and commitments in the fourth quarter did not have much impact in the fourth quarter. And what you really see in the quarter significant increase is more than 80% increase in net income. As I mentioned in the prepared remarks, it was largely due to originations of new loans but particularly the originations done in the fourth loan have the most significant impact really in the first quarter, not in the fourth quarter.

Michael Rothenberg - Moab Partners

Right, okay. Got it. It might make sense if you have another quarter like the fourth where the originations come very late to talk about a run rate earnings from that side of the business if you have a dynamic like you did it on the fourth quarter. Okay. That's all my questions, thank you.

Tae-Sik Yoon

Thank you.

Operator

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

Jade Rahmani - KBW

Thanks for taking the question. Can you just describe the gain on sale of loans line $680,000 what drove that? And also the income tax benefit actually it was I think you had a net income tax benefit which I assume was driven by the mortgage banking loss. So just those two items.

Tae-Sik Yoon

Sure. Good morning, Jade, thanks for your questions. Yes, in terms of the $680,000 gain and that is as you will see in the segment reporting attributable to the principal lending segment, there is more disclosure in the 10Q about this loan particularly, but this relates to the sale of what we call the gray stone senior loan sale. This was a loan that we originated back in the fourth quarter and, as you will notice in the balance sheet at year end, we actually had a loan that we classified as available for sale. That loan was successfully sold into our business plan in the first quarter. And when we sold a loan we recognized a part of the origination fee and the exit fee that were not sold to the purchasers of the senior notes. And so the $680,000 represents basically the gain on recognizing the fee that were not sold as part of the two senior notes that we sold.

And then you will also see that because we held that based on senior loan available for sale we held it within a taxable REIT subsidiary because that was our intent and our plan to sell that loan. So we held that loan in a taxable REIT subsidiary. That taxable REIT subsidiary obviously is a taxable entity and that's why under principal lending in connection with the $680,000 gain you also see a $241,000 tax expense associate with that gain.

And then going to your second question in terms of the tax benefits, right, we ended up with a net tax benefit on a consolidated basis $674,000 and that has to do with again the tax benefit that we would expect from the pretax loss that we incurred for the mortgage banking business at ACRE Capital.

Jade Rahmani - KBW

Okay. And so just regarding that $5.3 million run rate or the $5.3 million that the principal lending business we should actually back out the $680,000 unless there are other similar gains you expect to generate?

Tae-Sik Yoon

Well, yes, I mean there is a lot of ways to obviously look at the numbers. If you look towards to our history there has been a lot of what are generally classified as one-time items. Obviously, when you started to have a number of one-time items they may be different one-time items but number of one-time items I think you should take into consideration that aspect of it, but that's right, we would not expect gain until loans itself to be a run rate item as to described it.

Jade Rahmani - KBW

Okay. I mean just regarding the dividend what to be rationale behind maintaining the dividend and essentially paying part of it out of book value at this point?

Tae-Sik Yoon

Well, I think the rationale is our goal as to maintain a consistent dividend level and, as we mentioned in both our prepared remarks and responses some of our questions, it is our goal and it is our belief that, we will starting into second half of this year, that we will start to earn our dividend. So we believe the best course of action is to hold the dividend steady at this point and again that's (inaudible) our business plan.

Jade Rahmani - KBW

Okay. I think in the past it talks about a leverage target of 2 to 2.5 times. There's other players that are considering higher levels of leverage and given competition as well as a healthier state of real estate lending from when you originally provided that target, are you considering increasing that target or actually what drives your comfort with leverage at this point?

Tae-Sik Yoon

Sure. Good question, Jade. I think as the market evolves, as our capital structure evolves, as we continue to scale our business and as we continue to really focus on senior loans, the one of the things you notice is that, at March 31, 2014, 95% of our loan portfolio on our principal lending business as measured by outstanding principal as comprised of senior loans. As you can also tell that our portfolio has continued to perform very well and we have recognized since we went public, we recognize no impairments, no defaults. So we have to take into consideration all of those factors when considering what is the appropriate level of leverage.

I think we have also successfully demonstrated our ability to tap alternative sources debt capital. Clearly, we did commercial mortgage-backed securitization back in November of last year. At that point, as we mentioned on our call, that effectively resulted in about an 80% advance level or the equivalent of call it 4 to 1 debt to equity. But again because of that facility, that securitization itself was non-recourse and obviously, by its terms match funded, both in terms of interest rate risk and term, we felt very comfortable that that was the right strategy to apply.

So I think when we are looking at leverage levels, we certainly take into consideration our overall debt-to-equity ratios, our overall LTV ratios. But again, we want to be very specific in taking into consideration what type of borrowing facility we are taking about, continuing to match on the interest rate exposure, continuing to match on the term, continue to look for alternative sources, a diversification, if you want to call it, of our financing sources. So all of those factors and more are taken into consideration when coming up with what is a so called right level of debt-to-equity, right level of loan-to-values.

The other thing I just mentioned before, I think Todd wants to probably add a comment on this as well, is that a different parts of our company cycle, I think you will see different levels of leverage. So for example, I think if we are preparing to do a securitization or if we are preparing to do some offering, I think it would be advantageous for our company to take on a bit more incremental leverage so that we have the asset and we have the capacity to do the right size offering and/or securitization. So again, depending upon this page where we are on the capital cycle, I think you will see different levels of leverage.

Todd, did you want to add anything to that?

Todd Schuster

No. I think that actually pretty much covered it. I just want to reiterate that we think the quality of our portfolio both from a credit perspective, from a match-funded -- the fact that portfolio is match-funded on asset liability basis, the fact that most of them are -- most of the mortgages almost with 95% are senior mortgages, all of that gives us -- those things collective give us comfort around issues as they relate to leverage.

Jade Rahmani - KBW

Great. Thanks for taking the questions.

Tae-Sik Yoon

Absolutely. Thanks, Jade.

Operator

We have no more questions. I would like to turn the conference over to Todd Schuster for closing remarks.

Todd Schuster

Thank you, operator. And thank you everyone for your time and questions today. If you have any follow-up, please reach out to our IR Department. And thanks again for your support. And we look forward to speaking with you next quarter.

Operator

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 May 20, 2014 to domestic callers by dialing (877) 344-7529, and to international callers by dialing area code (412) 317-0088. For all replays, please reference conference number 10044227. An archived replay will be also available on a webcast link located on the home page of the Investor Resources section of our website. Thank you.

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Source: Ares Commercial Real Estate's (ACRE) CEO Todd Schuster On Q1 2014 Results - Earnings Call Transcript

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