Ares Commercial Real Estate Corporation (NYSE:ACRE) ("Ares CRE") is a specialty finance company that operates both as a principal lender and a mortgage banker with respect to loans collateralized by multifamily and senior-living properties. The firm's principal lending business is primarily focused on directly originating, managing and servicing a diversified portfolio of commercial real estate investments, and the mortgage banking division (managed through a subsidiary) originates, sells and services multifamily and senior-living related loans under programs offered by the government and government-sponsored entities ("GSEs"). The firm is classified as a REIT, and its financial statements consolidate the company's various variable interest entities ("VIEs"). Ares CRE is an externally managed subsidiary of Ares Management, L.P. (NYSE:ARES), an alternative asset manager with +$160B of AUM.
The company is divided into two divisions: principal lending and mortgage banking. The principal lending division was historically the largest revenue (and operating profit) generator for the firm, but this growth has shifted to mortgage banking. The principal lending group derives net interest margin from the interest from loans held for investment while the mortgage banking division generates income through servicing fees and "mortgage banking activities," which actually means for services such as the initial fair value of mortgage servicing rights ("MSRs"), origination fees for the loan, gain on the sale of loans, interest income on loans held for sale, and changes to the fair value of derivative financial instruments.
In FY2013, the principal lending division generated ~75% of revenue, but by FY2014, this was only ~58% of revenue. In the latest quarterly filing, as shown below, the principal lending division in 3Q only generated ~51% of revenue, although the division accounts for ~68% of net income for the firm.
(Source: 3Q '15 10-Q Filing
It is difficult to find true peers to benchmark the company's performance as the commercial real estate landscape is diverse and contingent on the origination practices and opportunity mining of the company at hand. We would note that the firm's stock price had held up relatively well throughout the course of last year, even as peers were struggling (from August to November). In December, the tune changed, and the shares have come down (20%) even though the firm was in line with guidance. We think this decline was due to macro factors (as peers also dipped in December and through January).
Source: FactSet - in $M except per share
While smaller in size than many peers, which could subject the company to more volatility, we see several reasons to be positive on the prospects for the firm:
1. Complementary businesses in the mortgage banking and principal lending
The mortgage banking business continues to grow and is complemented by the principal lending business. The principal lending business can use the funds generated from mortgage banking sales for additional originations and investments. As such, the mortgage banking business's ability to sell originations to third parties and government sponsored entities ("GSEs") initiates a virtuous cycle for the company. Given the growth in this segment over the past several quarters, we believe there will be a lagged effect on growth (as it takes time to invest capital from potential sales of mortgages).
Source: Company filings
The mortgage banking business is driven by the GSE production growth. Both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) comprise the majority of the mortgage banking business. Additionally, with respect to its ability to continue to grow, the firm has a strategic advantage due to its corporate structure. The combined professionals of the Ares CRE capital markets and the Ares Real Estate group offices span the globe, providing access to a network of investment professionals. This facilitates information gathering on potential originations.
Source: Investor Presentation December 2015
2. The new term loan facility has gone relatively unnoticed by the market
In December, the company entered into a new $155M term loan agreement with Highbridge Principal Strategies as administrative agents. The loan will have a base rate of 6% over one-month LIBOR, subject to a LIBOR floor of 1%, which, given the forecast one-month LIBOR rates of 0.85%, should make the effective rate ~7%.
The term loan was issued to cover an old set of convertible notes which were coming due at the end of the calendar year for $69M. With a fresh term loan in place, Ares CRE can increase its principal lending origination volumes and continue to grow the business. Additionally, the firm's dividend (LTM net dividends showed below) has remained constant since 2014, which is an anomaly in the peer group. The firm has been able to cover its dividend with earnings for the past four quarters, and we believe it is likely that the company will increase its dividend.
3. Growth in commercial real estate environment
Lastly, as mentioned on the 3Q 2015 earnings call, management is seeing a strong uptick in demand for floating rate commercial paper. The firm is well positioned to capture this trend due to this new term loan, its high debt capacity level, and its composition of floating interest rate borrowings and loans. The chart below describes the loan origination activity and the positive uptick in 2Q'15 and 3Q'15 above historical trends.
Source: JMP Securities November 2015
The firm also has a diverse capital base with additional debt capacity. The convertible notes on the bottom of this chart (in dark blue) have been retired and replaced with a new $155M loan. This provides additional dry powder to continue to originate and invest. Given that real estate valuations are at the most diverse level in almost a decade, we believe this is a good time to be invested in the market with professionals (and the diversity in the market is exemplified by the spread between mean and top-quartile cap rates below).
Source: Investor Presentation December 2015
We valued the firm with a multiples based approach that emphasizes the Price to Book Value of peers and of the firm's historical range. The current valuation is currently in line with the historical dividend relative to peers, which is ~30% below a peer average.
Our base case assumes that the firm continues to meet its quarterly dividend with net income and grows the dividend by 10% this year, which would inspire additional investor confidence. We also assume the Price to Book Value recovers to be at the median of the peer range. In an upside-case scenario, we believe the Price to Book Value would reset to the top of the peer range given Ares CRE's association with Ares Management and the diversity of the underlying capital and geography. In a downside case, we assume the firm trades down to the lower end of the peer range.
Source: Our estimates
There are several risks that deserve mention. Given the opportunity in the real estate market, we also acknowledge that there could be significant shakeup in the performance of REITs over the coming year(s) and the macro uncertainties will likely continue to weigh on the industry. Here are some of the primary risks we identified:
- Deterioration of the commercial real estate market: If tenant quality deteriorates or the commercial real estate market goes through a cyclical downturn, the revenue and profitability metrics of Ares CRE would be jeopardized. This could have broad-ranging impacts including an inability by the company to cover its dividend through quarterly earnings, which would be taken negatively by the market.
- Investment performance of the principal lending group: Given this group makes a variety of commercial real estate related investments into CMBS, senior debt, or preferred equity, and if one of Ares managers underperforms, that could have a negative impact on the entire portfolio. Ares CRE has not had an issue with defaults or uncollectible loans in the past.
- Access to future financing: Future financing is necessary to be able to grow the business. The extent to which future financing is available to the company at competitive rates and in a timely fashion depends on the broader economic market and is a source of risk.
We find Ares CRE an interesting company in the realm of commercial real estate investment firms. It is not a high conviction name for us given the macro uncertainty and the lack of clarity on interest rates. Overall, the firm has a complementary product offering, and it provides exposure to an area of investment dislocation (the real estate market). If Ares CRE continues to grow, and reaffirm its confidence with an increase in the dividend, we think the stock could be worth ~$13-14 per share.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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