The commercial real estate sector remains a good place to find some bargains. In this article, I’m focused on Ares Commercial Real Estate Corp. (ACRE), whose stock price has fallen by 40% since the start of the year. While risks still remain, I believe the market has overly-punished this commercial mortgage REIT. I evaluate what makes this an attractive investment at present; so let’s get started.
(Source: Company website)
A Look into Ares Commercial Real Estate
ACRE is a commercial mortgage REIT that is externally-managed by the well-renowned investment manager, Ares Management (ARES). Through this affiliation, ACRE is able to leverage the Ares investment platform to obtain incremental deal flow and market intelligence from Ares’ broader resources, relationships, and experience.
What I like about ACRE is its conservatively-minded focus on senior mortgage loans, which comprises 95% of ACRE’s portfolio. Its portfolio is also well-diversified geographically, with 40% of its loans in the Southeast, 20% in the West, 18% in the Midwest, and the remaining 22% in the Southwest/Northeast regions of the U.S. In addition, management has a recent track record of growing its dividend, with a 5-year dividend CAGR of 5.7%.
One of the challenges that I see for ACRE is its exposure to sectors that are more exposed to effects of COVID. As seen below, the challenged Hotel and Office sectors represent 13% and 28% of ACRE’s loan portfolio.
(Source: Company Earnings Presentation)
This impacted ACRE’s second quarter core earnings, as it dipped on a YoY basis to $0.32 per share, as compared to $0.38 per share in the prior year’s quarter. This was mainly attributed an unrealized loss on 3 loans that were subsequently sold during Q3. In addition, ACRE’s REO (real estate owned) property, Westchester Marriot, had a loss of $0.06 per share due to declines in travel. Looking forward, I do see reasons for optimism, as management has been proactive with converting this asset into a limited service model. In addition, management noted that this asset will benefit from a significant reduction in competition, as a few neighboring hotels are closed or expected to close.
While I expect continued challenges for ACRE’s portfolio clients in Q3 and for the remainder of the year, I do see positive signs emerging. For one thing, 100% of ACRE’s loans held for investment made their contractual debt service payments through July, including three loans that remain on non-accrual status. In addition, the company’s internal risk rating has shown improvement. As of August, management noted that 91% of its loans were rated at 3 or better (on scale of 1-5), as compared to 84% during the Q1 reporting period.
ACRE’s balance sheet remains consistent, with a debt-to-equity ratio of 2.9x , which remains unchanged on a YoY basis, and a reduction from 3.2x during Q1. The company also maintains plenty of liquidity, with $80M in unrestricted cash. Looking forward, I expect the company to continue deleveraging, as management noted that as being one of the priorities during the last conference call.
In the meantime, I see ACRE as benefiting from the currently low interest rate environment, which the Fed Chairman expects to continue through at least 2023. That’s because 100% out ACRE’s outstanding financing is floating rate, while nearly all of ACRE’s loan portfolio has LIBOR floors. This has the effect of capping the downside on earnings, while providing continued benefits in the form of savings on interest expense. As seen below, management expects an annual $0.06 per share benefit from the effect of LIBOR rates at zero. I see this as providing a good offset to potential future losses, as management navigates the current economic environment.
(Source: Company Earnings Presentation)
Turning to valuation, I see ACRE as being attractively valued. At the current price of $9.56, it is trading at 68% of its book value, using the more conservative $13.91 value including CECL (current expected credit losses). For comparison, ACRE traded at a 7% premium to its book value at the end of 2019. Analysts seem to agree that the shares are undervalued, with an overall Buy rating (score of 4 out of 5), and a price target of $10.30.
I also find the 13.8% dividend yield to be attractive. While the Q2 dividend was slightly under-covered by Q2 earnings, I expect to see better coverage in the coming quarters, considering the aforementioned improved risk ratings that management has seen in the overall portfolio.
ACRE is a leading commercial mortgage REIT that benefits from its affiliation with its big brother, Ares Management. It is conservatively run, with 95% of its loan portfolio as senior loans. The company has seen some challenges during the current recession, most notably of which came from the Hotel sector. I’m encouraged, however, by the improved risk ratings that management has assigned the portfolio on a sequential basis.
In addition, ACRE can actually benefit from low interest rates, due to savings on interest expense on its 100% floating rate financing and LIBOR floors on its loan portfolio. Lastly, the shares are trading at a significant discount to book value including the CECL reserve. While I would like to see better dividend coverage, the 13.8% yield appears attractive in this low-yield environment. I see ACRE as a turnaround play with upside potential from the current price.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.