Participants

John Stilmar; IR; Ares Commercial Real Estate Corp

Bryan Donohoe; Chief Executive Officer; Ares Commercial Real Estate Corp

Tae-Sik Yoon; Chief Financial Officer, Treasurer; Ares Commercial Real Estate Corp

Doug Harter; Analyst; UBS AG

Jason Sabshon; Analyst; Keefe, Bruyette, & Woods, Inc.

Stephen Laws; Analyst; Raymond James & Associates, Inc.

Steve Delaney; Analyst; JMP Securities LLC

Rick Shane; Analyst; JPMorgan Chase & Co.

Presentation

Operator

Good morning, and welcome to the Ares Commercial Real Estate Corporation's first quarter earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded on Thursday, May 9, 2024. I will now turn the call over to Mr. John Stilmar, partner of public markets, Investor Relations. Please go ahead.

John Stilmar

Good morning, and thank you for joining us on today's conference call. I'm joined today by our CEO, Bryan Donohoe; our CFO, Tae-Sik Yoon, and other members of the management team. In addition to our press release in the 10-Q that we filed with the SEC, we've 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 as well as the accompanying documents contain forward-looking statements that 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 and management's judgment. Statements are not guarantees of future performance, condition 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 result of a number of factors, including those listed in its SEC filings. as commercial real estate assumes no obligation to update any such forward-looking statements.
During this call, we will refer to certain non-GAAP financial measures. We use these as a measure of operating performance. These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like titled measures used by other companies.
Now I'd like to turn the call over to our CEO, Bryan Donohoe. Brian?

Bryan Donohoe

Thank you, John. During the first quarter, we made meaningful progress towards our goal of resolving underperforming loans, reducing the outstanding principal balance of nonaccrual loans by $133 million, as well as reducing our exposure to the commercial office property sector by $70 million or 8% of our total loans backed by office properties.
By addressing a total of four nonaccrual loans during the first quarter, we increased our distributable earnings excluding losses compared to the prior quarter by approximately $0.02 per common share and further delevered our balance sheet by $138 million to an outstanding balance of less than $1.5 billion at the end of the first quarter.
Our focus remains on returning ACRE to its core business of originating loans and managing a portfolio of loans backed by commercial real estate properties in order to earn consistent income to support an attractive level of dividends for our shareholders.
Let me now provide more details on the loans that were resolved during the first quarter. First, we sold a $38 million loan that we held for sale at year end 2023. That was backed by a mixed-use property located in California that was on nonaccrual.
Second, we agreed to a discounted loan payoff of a $19 million loan backed by a multifamily property located in the state of Washington that was on nonaccrual, the end of 2023. As a result of these initiatives, we realized a loss consistent with the fair value mark and loss reserves held on our balance sheet at year end 2023, and paid down $54 million of debt in our FL forward securitization.
Third, we exited a $57 million, Chicago risk-rated five loan collateralized by a commercial office property that was also on non-accrual at year end 2023. As a result of this disposition, we realized a loss that was $3 million higher than the loss reserve held against this loan at year end 2023.
And finally, we restructured a $74 million loan backed by a class-A, newly rebuilt office building located in New York City. At closing of this restructure, the borrower paid down $5 million of principal, reducing the balance to $69 million, which was split between a $59 million A-note and a $10 million B-note.
In addition, it is anticipated that the borrower will contribute additional capital into the building for additional lease new leasing costs, including tenant improvement allowances. To incentivize the contribution of additional capital, including the initial $5 million repayment of the loan, we have agreed to subordinate our $10 million B-note to new equity contributed by the sponsor.
This restructuring resulted in returning the $59 million A-note to interest earning status while the B-note remains on nonaccrual. As a result of addressing these four loans, the outstanding principal balance of loans on nonaccrual was reduced by 31%, and our distributable earnings, excluding losses increased by $0.02 per common share for the first quarter of 2024.
Shifting now to our overall portfolio, we ended the quarter with $2 billion of outstanding principal balance across 44 loans. 36 loans totaling $1.5 billion or 75% of our loan portfolio had a risk rating of three or better. The majority of these loans are collateralized by multifamily, industrial, self-storage and hospitality property.
As a reflection of the quality are risk-rated three or better loans, borrowers continue to be committed to these underlying properties. Over the past 12 months, borrowers have contributed more than $130 million in additional capital relating to loans, risk-rated three or better. And during the same time period, all interest rate caps have been renewed at their prior strike or economically equivalent amounts have been deposited into reserves.
Going forward, we will continue to focus on resolving our remaining four and five risk-rated loans and to reduce our office exposure. During the second quarter, we expect to take a $33 million risk-rated five loan backed by an office building in California as REO that is currently on nonaccrual. At this time, we believe that our loss reserve on this loan is substantially in line with our current estimate of a potential realized loss.
Additionally, despite ongoing negotiations with the borrower, a $69 million loan to an office property located in North Carolina currently on non-accrual, defaulted after quarter end. We have begun the process of taking title of the office property and importantly, this property is cash flowing such that if and when the property becomes REO, property level earnings will be recognized. With that, let me turn the call over to Tae-Sik to provide more details on our financial results and balance sheet position.

Tae-Sik Yoon

Thank you, Bryan, and good morning, everyone. For the first quarter of 2024, we reported a GAAP net loss of $12.3 million or $0.23 per common share. Our distributable earnings loss for the first quarter of 2024 was $33.5 million or $0.62 per common share and was driven by a realized loss of $45.7 million or $0.84 per common share due to exiting the three loans that Brian mentioned earlier.
Distributable Earnings, excluding these realized losses were $12.2 million or $0.22 per common share for the first quarter. Our overall CECL reserve now stands at $141 million, which declined by $22 million versus the $163 million CECL reserve we held as of December 31, 2023. This reduction was driven by a $42 million reversal of existing reserves associated with the realization of losses. Partially offset by approximately $20 million of additional reserves on existing loans in the portfolio.
The overall CECL reserve of $141 million at quarter end represents 6.9% of the outstanding principal balance of our loans held for investment, which is down from 7.6% as of the prior quarter. 89% of our total CECL reserve or $125 million relates to our risk rated four or five loans, including $31 million of loss reserves on our two risk-rated five loans and $94 million of loss reserves on our six risk-rated four loans.
Overall, the $125 million of reserves on our risk rated four or five loans represents 25% of the outstanding principal balance of such loans. Further, with respect to our loans that are risk rated four or five at quarter end, there were eight loans totaling $503 million in outstanding principal balance. 77% of the outstanding principal balance of our risk rated four or five loans are collateralized by office and one residential condominium property.
We did downgrade $197.5 million Texas multifamily loan to a risk rating of four from three during the first quarter as a time line and process of the sale of the underlying property by the borrower it has been extended.
Before concluding, I want to provide more background on managing our balance sheet. Consistent with our goals, we continue to maintain significant liquidity and further reduced our third-party debt. Driven by the loan exit activities during the first quarter, we reduced our outstanding borrowings by $138 million, resulting in total third-party debt of less than $1.5 billion at March 31, 2024.
And finally, we declared a regular cash dividend of $0.25 per common share for the second quarter of 2024. The second quarter dividend will be payable on July 16, 2024, to common stockholders of record as of June 28, 2024.
With that, I will turn the call back over to Bryan for some closing remarks.

Bryan Donohoe

Thank you, Tae-Sik. We are cautiously optimistic that the modest recovery we are seeing in the commercial real estate markets and tightening spreads in the CMBS capital markets will be supportive in the execution of our near term goals.
We are firmly focused on addressing our underperforming loans and further building liquidity in order to maximize outcomes as we seek to shift our focus from asset management to investors. The timing and path to resolving some of our current four and five risk-rated loans may make our quarterly earnings trajectory uneven this year, including in the second quarter due to loan resolutions.
We remain focused on resolving a number of the identified risk-rated four and five loans in 2024, which we believe will enable us to achieve higher distributable earnings. As always, we appreciate you joining our call today, and we'd be happy to open the line for questions. Operator?

Question and Answer Session

Operator

(Operator Instructions)
Doug Harter, UBS.

Doug Harter

Thanks, and good morning. You talked about using the potentially move going back to investing, this quarter we use the resolution proceeds to pay down debt. Just, how should we think about when you might pivot to investing versus continuing to delever the balance sheet?

Bryan Donohoe

Yeah, appreciate the question, Doug. Good to hear from you. I think the playbook remains fairly similar to what we've said in prior quarters, which is a multi-pronged path towards resolution where we're considering a lot of options with the pursuit of generating more liquidity, which would give us -- then the optionality as to when we see the opportunities which have started to present themselves beginning in Q4 with some of the rate stability we saw, a bit of a pause with the rate movement of the past six or eight weeks. But ultimately, we are seeing more liquidity, more acceptance of revised asset values.
And ultimately, as we work through the coming quarters, we would intend to get back to that offense of side of the ledger once we've crystallized some more liquidity on the balance sheet. So the primary goal is to continue to resolve those risk-rated four and five and the liquidity that should come where those types of resolutions will allow us that flexibility.

Doug Harter

Appreciate that, Bryan. And Tae-Sik, can you give us some sense on what sort of drag the four resolve loans, excluding the losses had on earnings during the first quarter and kind of how to think about the path back towards the dividend?

Tae-Sik Yoon

Sure. Thanks for your question, Doug. As we mentioned, the four loans that were either exited or restructured this quarter. So really the resolution of those four loans, either through, for example, the restructure loan having then A-note come back on earnings and then the three exit loans really paying down debt.
The combination of that really added around $0.02 of distribal earnings during the first quarter. That run rate, if you want to call us at the end of full quarter impact of that will be higher than the $0.02, but for the first quarter, I think it was roughly $0.02 positive impact that it had on our first quarter earnings.

Doug Harter

Great. Thank you, [team].

Tae-Sik Yoon

Thank you, Doug.

Operator

Jade Rahmani, KBW.

Jason Sabshon

Hi, excuse me, this is actually Jason Sabshon for Jade Rahmani. It would be helpful to hear an update on how things are going with your repo lenders and on the term loan.

Bryan Donohoe

Sure. Good morning. Tae, you want to kick off?

Tae-Sik Yoon

Yeah, no, thank you. Thanks for the question. I think we've had and always maintain what we think is a very strong relationship with all of our lenders, warehouse lenders, term loan lenders, revolving credit facility lenders.
And in fact, as you'll notice in our filing this morning, we have continued to work with them and we greatly appreciate the partnership we have with all of our lenders. But you can see that we continue to -- for example, amend our credit facility so that we can, again as part of our overall goal to resolve underperforming loans, optimize the balance sheet with flexibility.
So flexibility is very important to us. And again, we appreciate all the partnership, we've at our lenders who have been willing to work with us. It create that additional flexibility on our balance sheet.

Jason Sabshon

Great. Thank you. Also on the North Carolina office loan default, it would be helpful to hear more color on how you see that playing out?

Bryan Donohoe

Yeah, I'll give that a shot. I think look, we obviously were attempting to work with the borrower. However, the capital necessary for us to restructure that loan in keeping with what we accomplished on the New York loan that we covered in the prepared remarks, didn't necessarily make it rational. It's also an asset, as we mentioned that, has positive cash flow, probably has some occupancy upside in a market that has seen some positive flows of corporate tenancy.
So we think there's some value to be added with a functional ownership group. So I think that the time line for resolution there will be what it will be. I don't think it's a one to two quarter resolution necessarily. But when we look at situations like this, clearly, we want to see both expertise and capital come to bear on those assets.
And as you see in our earnings deck, we feel that we're in a position to bring both of those as a fallback position to having attempted to work with the borrower. So the time line will be determined over the next 60 days to 90 days. And I think when we chat with you all in 90 days, we'll have a more concrete plan there.

Jason Sabshon

Great. Thank you. And as a final question, understanding that each asset is unique, but generally in your book, how have lost severities compared to your expectations, specifically for office and multifamily loans and general commentary on what you're seeing in the market with respect to loss severities would be helpful as well?

Bryan Donohoe

I'll start it. Look, I think what we've attempted to do over the past prior quarters has been to give our best estimate of where we expect to resolve assets and really limit surprises on these calls or dramatic changes in our outlook. And I think we've had some success doing that.
As an industry, I would put forth that at what's gone on in the office sector has surprised many to the downside in terms of resolutions. That said, we've been as transparent as possible as we've worked through those. I think the lack of transparency generally in the market has probably delayed some resolutions throughout the broader space and I think as I said earlier, we're starting to see that crystallize to some degree with stability in rates. So I think over the coming quarters, you'll see more resolutions in keeping with expectations.

Jason Sabshon

Great. Thank you.

Operator

Stephen Laws, Raymond James.

Stephen Laws

Hi, good morning. -- at the risk of asking something you already mentioned, Bryan, was a few minutes late, but can you talk about the nonaccruals, I think it was I believe it's 292 remaining. I know you guys made a lot of progress, but is there a goal on a summer near term resolution, some are longer term, but maybe if you look to year end, do you have say an idea of where you'd like to exit the year at that on that number?

Bryan Donohoe

Yeah. Thanks for the question, Stephen, and I'll start and I'll let Tae-Sik chime in as well. I think, well, part of the challenge of the industry is measuring a lot of what we do by quarter, but certainly year end. That's a good hallmark day to turn the page, so to speak, philosophically and financially.
I think what we see is -- especially with the offense of side of the market being so compelling that while managing resolution price, we're going to balance that with resolution timing. So our conversations with borrowers if you were to go back what feels like a long time ago, three plus years where extending duration of assets on the book was really the primary playbook as we sit here today, we'd like to resolve assets and crystallize a lot of those resolutions and get back to the offensive side as soon as possible.
So tough to put demarcation lines in terms of the calendar. However, certainly when we look forward into three quarters to year end, that's a pretty good place to plant a flag. But Tae-Sik feel free to add some color there.

Tae-Sik Yoon

Yeah, Brian, I think you covered it well. Stephen, I mean, I think you probably heard from our opening remarks that resolving our underperforming loans, certainly including the nonaccrual loans is really one of our top, top, top priorities. We're hyper focused on that effort. We think that will bring a lot better clarity to our balance sheet as well as the accretive to our earnings, as we mentioned. But as Brian said, I think it's very difficult to provide precise numbers.
We did resolve, as we mentioned about four loans this past quarter and we hope to continue to report some news on further resolutions in the quarters coming ahead.

Stephen Laws

Right. That was the main one to add today, so appreciate your comments this morning.

Tae-Sik Yoon

Right. Thank you so much, Stephen.

Operator

Steve Delaney, Citizen's JMP.

Steve Delaney

Good morning, Bryan, it's ectic, busy quarter for you and it sounds like it's continuing. With the four loans, nonaccrual loans that you reworked, resolved in the first quarter and then the two office REOs in the second quarter having a little trouble. I've had no chance to go to the deck and just roll all this through. But as we -- after these second quarter REOs, can you tell us what is left at this point in five rated loans after the REO, the two REOs?

Tae-Sik Yoon

Sure. I can -- see if I can take a shot at that. Yeah. So as we mentioned, there are eight loans that are risk rated four and five as of quarter end.

Steve Delaney

Okay.

Tae-Sik Yoon

And certainly it includes the two office properties that you mentioned, that we anticipate ongoing REO in the future. We also mentioned a new four rated loan, $97.5 million multifamily loan. And as we mentioned in our closing remarks, the reason it was downgraded from three to four, is that the sale process of the underlying property, this multifamily property in Texas.
It's just taking a bit longer than we had originally anticipated and so because of that, it was downgraded. So that's really call it three of the eight loans, again, the two REO plus the one multifamily loan. And then when you really look at the remainder of the portfolio, what you have is you have some loans that have been kind of on our balance sheet profile.
We mentioned, for example, one of the mezzanine loans, that we put on nonaccrual. And I'm just -- and then really it is the condominium development that we have in New York. And then it's the large office loan out in Illinois, and it is an industrial asset out in California, so the $20 million loan out in California. So I think that covers just trying to recollect others. I think that makes up the remaining five loans that are in the four and five rated loan category.

Steve Delaney

[Bob] ones, as we sit today, less than four and five. And I understand this is fluid and things are going to be coming and going. But nice to see some resolutions and some progress there.
Bryan, I know this is a decision the Board goes through probably every month or every -- certainly, every quarter. But the issue of your current $0.25 dividend and working to maintain that and the opportunity for share buybacks, I would guess, even with the loss of book value, still probably a little below 70% of book.
How are you thinking about that in this market where everybody having problems and you're looking at your stock with a mid-10s dividend yield just your thoughts, please, on how the company, your shareholders are best served between paying out that cash or buying back your shares here.
I didn't notice that you bought in shares in the first quarter, if I overlooked that, please let me know. Thank you.

Bryan Donohoe

Now that. I appreciate the question, Steven. As you said in your prior comments, the market is fairly fluid and it is something that the Board and management considers each quarter as we characterize when we chatted 60 days, 90 days ago, what we established when with the dividend at 25 was what we felt was attainable over the near to medium to long term, right? And I think that's something that we will continue to evaluate.
And over the past 18 months. I think we, as an industry have contemplated the best way to serve our shareholders and that is a combination of dividend, which is the core charge, I think of the mortgage rate business as well as the relative value of buying back shares, which we've done previously.
So it's a balanced approach alongside managing liquidity and ultimately crystallizing the best returns possible for our investors. So I wouldn't put forth, I think we'll continue to evaluate that in the coming quarters based on the results of that fluid market, you mentioned.

Steve Delaney

Got it. Glad to hear that it's going to remain on the table regardless of your -- I know you bought to make the right decision quarter by quarter. Thank you both for your comments.

Bryan Donohoe

Thanks, Steve.

Operator

Rick Shane, JPMorgan.

Rick Shane

Hey, guys, thanks for taking my questions this morning, and I apologize if some of this has been covered. First as you sort of move from paying down the -- shrinking the balance sheet to moving back to offense. I'm curious if there are any covenants that you need to be aware of or any limitations related to your debt that could make that more challenging?

Tae-Sik Yoon

Yeah, Rick, thanks very much for your question and good morning. As we mentioned in our response to some of the prior questions, we have been actively in dialogue with our lenders. And as you'll notice in our filing this morning in the Q that we are starting to make some amendments to those facilities to make sure that we have the flexibility to implement the strategy that we talked about, right?
So far, our strategy, as Bryan mentioned, is to focus on resolving our underperforming loans. And in order to do that we want to make sure we optimize the balance sheet to provide that flexibility. Deleveraging has been certainly a big part of that strategy as well as maintaining good levels of liquidity and so we continue to focus on those two elements.
And then again, we're proactively working with our lenders to make sure that the covenants and the loan facilities provide us that flexibility to attain the overall objective of resolving underperforming loans. So the answer to your question is yes. We are we are definitely proactively working with our lenders on this.

Rick Shane

Got it. Yeah, I did a search of the queue for covenant amendment and I got 150 of each. So I didn't -- I wasn't able to find the answer, I'm sure it's in there. Second question, look, if we look at the forward curve and compare one month forward, so for 25 today versus where it was in January, expectations are -- rates are up 100 basis points to 125 basis points from where expectations were in January. I am curious in your conversations with borrowers or what you're seeing if that expectation that rates are going to be so much higher for longer. And again, it's the forward curve.
So we have to take it with a grain of [salt], but is that driving capitulation is driving people's behaviors to change in a material way from what our sentiment was even at the beginning of this year?

Bryan Donohoe

Yeah, good question, Rick and I have a few questions in there and I'd say summarily, yes. I think that the stability in the rates in Q4 was catalytic in terms of causing some transactions to be consummated. And I think we saw a good pop of activity in Q1, much of which was in the headlines in terms of apartment industrial trades and fairly sizable ones.
I think that started the process and maybe capitulation is in a perfect word, but for the real estate market, to get back to forward looking into consummate transactions and so while the rise in rates since that period of time has not been accretive to values, right? It's clearly in the public and private markets, you'll see a strong correlation to rates in terms of the prints.
I do think that the trend started to leave the station to some degree and therefore, we expect people to either realize that their assets are worth what they are worth and therefore move on. So there's a financial capitulation, but also the time allocation for legacy holders of assets is may no longer be worthwhile.
And on the other side of that, more positive tone would be that higher for longer means the yields available as a lender continue to be high and it widely publicized when there is this level of duress in the market, it can be a generational opportunity to invest in equities and structured debt, things like that.
So I think that the stability in rates and then the backing up is kind of either way going to lead to more resolutions, whether it's characterizes capitulation or great opportunities.

Rick Shane

I appreciate that, Bryan. Thank you so much, guys.

Bryan Donohoe

Appreciate it, Rick

Operator

And there are no further questions, I would like to turn the conference back to Bryan Donohoe for any additional or closing remarks.

Bryan Donohoe

Appreciate that, operator. Yeah, I just want to thank everyone for their time today. We appreciate the continued support of Ares Commercial Real Estate, and we look forward to speaking to you again on our next earnings call. Thank you.

Operator

And ladies and gentlemen, this concludes our conference for today. If you miss missed any portion of today's call, an archived replay of this conference will be available approximately one hour after the end of this call through June 9, 2024, to domestic callers by dialing 181007590728 and to international callers by dialing 14022207229. An archived replay will also be available on a webcast link located on the home page of the Investor Resources section of our website. Goodbye.