Description

Ares Commercial Real Estate Corp. (ticker: ACRE) is specialty finance company focused on originating middle market commercial real estate loans.  It is from the same group that manages Ares Capital Corp. (ARCC), a business development company (BDC) which has arguably had one of the better and more conservative management records in that space.

The thesis for ACRE is quite simple.  It IPO’d in April of this year at $18.50, and due to the familiar combination of having underwriting fees and a slow initial build out, immediately drifted to a discount to NAV and has remained there ever since.  Investors in the sector are primarily dividend seeking, and as ACRE utilizes its capacity and grows into its dividend, its valuation will trade closer to the NAV multiple of its peers.  Gives Ares reputation and the corresponding premium accorded to its BDC, one can also make the case that it should eventually be valued at a modest premium to NAV.

Ares CRE has already begun ramping up its dividend in anticipation of earnings, with a Q4 dividend of $0.25, and its current rate of deploying capital has it on target to earn at least $1.20 next year for a 7.3% earnings yield.  In addition to that, if ACRE were to trade up to 1.0x NAV, which is currently $17.99/share, that would add an additional 9.7% to the return.  It seems entirely reasonable that this conservatively deployed CRE lending vehicle could produce mid-teens to upper-teens returns over a  one year horizon, while providing the dual margin-of-safety of being currently discounted to NAV (0.91x) and deploying its capital conservatively.

There’s not much more to it than that. 

Well, plus the fact that as ACRE grows into something more like a 3:1 debt:equity ratio, the dividend could well approach $2.00/share.  In combination with accretion to NAV, the IRR would jump toward 20%.  As we’ve seen with these vehicles, eventually management works their way toward that balance point where they can get their stock to trade near or above NAV and begin the virtuous circle (for the management team) of regular accretive secondary offerings and AUM growth.

However, the reinvestment prospects for any lending portfolio is an obvious concern to all investors who look at banks, mREIT’s, and specialty finance firms, as is the details behind their operations.  It is an easy argument to make that a loan portfolio with an earnings yield below 8% should trade at a discount to NAV, and not merely a modest one.  What makes ACRE attractive is that given its risk profile and leverage, it should be able to grow toward an 11% ROE, and in its niche, that would represent a compelling enough dividend yield to attract investors to pay a premium to NAV.  On their most recent earnings call, they stated their belief that with a 2:1 debt-to-equity ratio, they can achieve a gross levered ROE of 12% to 13%.  It will just take some time, given the conservative roll-out of funds thus far.

First a bit of background on ACRE: for those familiar with the IPO’s of BDC’s, ARCC stood out for having a unique strategy for beginning its publicly traded life with a simultaneous transaction to acquire an already assembled mezzanine loan book.  Previous IPO’s had languished due to having no capital deployed and underwriting fees that immediately brought NAV down 7% from the IPO price.  Actually, it makes no sense to purchase any of these vehicles at the time of their IPO for these reasons.

ACRE came public with some subsidy from Ares, as Ares agreed to purchase 20% of the stock at an above market price of $20.00, versus the IPO of $18.50.  In effect, this ameliorated the NAV dilution given the $0.74/share of underwriting fees.  Still, it didn’t stop ACRE from falling to a more significant discount.  

ACRE is Ares attempt to take meaningful market share away in the middle market niche that it specializes in, with ACRE being its emphasis on commercial real estate and related transactions.  According to their first conference call, what they are doing is essentially “building up of our national direct origination platform, we want to be the leading alternative capital provider for experienced owners and sponsors of commercial properties seeking shorter term flexible financing to support their business plans of acquiring restructuring and/or repositioning their properties”.

While externally managed BDC’s and mREITs have healthy management and incentive fees, the example of ARCC shows that Ares is very intelligent in gaining additional fees through originating to control and syndicate.  Over the next five years, over $1 trillion dollars of CRE debt will mature, and ACRE represents an interesting pure play into the space.  Given the regulatory constraints on bank lending, it makes sense that being less leveraged (and regulated) in CRE lending is not such a disadvantage in the right hands.

The first post-IPO transaction that ACRE originated is a good example of what they are aiming to do.  It was a $14.3 million mezzanine loan that was used to facilitate the acquisition of a $100 million office building in the Buckhead/Lenox area of Atlanta.  The building is 94% leased and is well diversified with tenant mix, concentration, and has less than a third of the leases expiring in the next five years.  The initial yield on the loan is 10.7% with an initial LTV of 75% inclusive of the principal balance.

ACRE is assembling a diverse collection of CRE loans that they originate themselves, and they undoubtedly have some advantage of incumbency given their presence in the mezzanine and senior secured lending space.  While the above example is a mezz loan, and falls into that 10% to 12% range one would expect, they are also comfortable with doing whole loans, which are currently priced closer to 6% with LTV’s closer to 65%.

As of Q3, the weighted average rates in their lending portfolio has been 6.7% on approximately $168 million in senior mortgage loans and 11.2% for approximately $22 million in mezzanine loans for an overall weighted average effective yield of 7.2%.  The weighted average remaining life for all loans was 3.2 years.

One of the difficulties with judging a loan portfolio is getting a handle on how much adverse selection exists in the collection, and what would a true mark-to-market look like for a portfolio which is dominated by loans the borrower could not refinance?  It is interesting that the high dividend retail stock investor niches such as ACRE’s seems to struggle with getting the balance right between preferring non-legacy assets and wanting immediate dividend yield, between  getting that dividend versus getting gains via a positive revaluation of the NAV multiple.  And yet this niche seems to regularly offer up opportunities due to its aversion toward the lower-dividend, discounted-NAV ramping up periods of capital deployment.

 Of course, NAV multiples have a wide range in this sector, and there’s no guarantee of where ACRE eventually settles.  It also doesn’t help in that the mix of strategies, leverage ratios, assets and track record prevents easy apples-to-apples comparisons.  Just because Ares has a BDC that trades at a premium to NAV and a premium to its peers doesn’t mean that ACRE will accomplish both. 

However, even if ACRE doesn’t get to a premium to NAV, it can still establish a dividend higher than its current dividend yield and do so via conservative underwriting.  In that case, an investor who buys in at 91% of current NAV and simply gets the return accorded to a well managed lending business can probably walk away secure in the knowledge that the risk-adjusted return is appropriate. 

Some CMBS and CRE finance vehicles trade at a premium to NAV, such as CreXus (CXS) at 1.04x, while others like Colony Financial trade at 0.80x (closer to 0.82x before today’s secondary offering pushed it lower).

Most interesting to patient investors, is that the price volatility of ACRE’s stock is right in line with the volatility exhibited by banks such as Wells Fargo and PNC Financial.  November saw two violent plunges toward $15.00/share.  Mr. Market seems to be running hot and cold these days on specialty finance companies and dividend stocks.  While perhaps more understandable for banks, it seems a bit overdone for ACRE.  In the private market, an investor wouldn’t expect to see a blended portfolio of recent vintage three year maturity CRE loans have such volatile week-to-week swings.

Understandably, ACRE won’t have much appeal for many investors here.  However, it occupies an interesting niche within the lending and finance world, and it represents yet another way to buy a banking or lending business at a discount to tangible book value.  Most bank investors are focused these days on finding a discounted P/TBV situation with earnings power and the possibility of an upwards revaluation of the book multiple. 

There are many dynamics to investing in this space, and here are the tradeoffs that immediately come to mind:

• Price/Tangible Book or Price/NAV—in ACRE’s case, it would be nice to get more of a discount.
• Earnings yield—satisfactory enough, particularly given its ability to grow into a proper debt:equity ratio as it deploys capital.
• Asset mix—a matter of investor preference, no doubt, but the blend of senior and mezz with three year average maturities seems to represent a sweet spot for financing properties undergoing improvements and on an obvious path toward refinancing at maturity.
• Legacy assets—makes for a cleaner story whenever it is post-2008 loans, as it is in this case.
• Target multiple—unlike a cheap bank, which might be sold at a premium, any multiple increase here will need to be driven by a combination of producing a large enough dividend yield to merit a multiple to NAV or a risk-preference for ACRE given its conservative lending reputation.
• Interest rate and duration risk—with floating loans and short maturities, its primary risk is if the economy turns and the vehicle turns into another lending model of extend-and-pretend, which seems unlikely from loans made at this stage of the cycle.

ACRE’s combination of business model and valuation suggests an 8% to 20% IRR over the next twelve to eighteen months, while its earnings yield and business model provides a floor in the case of a re-pricing of the sector. 

DISCLAIMER:

This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned. 

Catalyst