Ares Commercial: Another distribution cut is likely within a year (NYSE: ACRE) | Private Equity Weekly

In our last coverage of Ares Commercial Real Estate (NYSE: ACRE) we give it a “sell” rating. What’s unusual about our position is that we’re taking this action despite falling stock prices.Generally speaking, we Tends to move our ratings in the opposite direction to the stock price. As the good news is priced in and the stock moves higher, we move from “buy” to “hold.” Conversely, when stocks fall, we recognize that bad news may be priced in and move from “sell” to “hold” or even to “buy.” When we wrote about ACRE, it had fallen 25% from its recent highs in a short period of time. So staring at “sell” is unusual. Our reasoning is that book value will be killed in the coming months, and its dividend safety also gets a terrible rating.

ACRE would be in danger of an “extreme” level of allocation cuts on our proprietary Kenny Loggins scale.

The rating implies a 50-75% chance of allocation cuts over the next 12 months. We rate this a Sell.

Source: Dividend cuts likely in 2024

It’s rare for an appeal to be so effective, with ACRE cutting distribution less than 12 days after the article was published. Given investors’ income flight, stock performance has been predictable.

We don’t think this is done yet and believe a second round of trouble is coming. Let’s review why.

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The first slide in the investor deck tells you a lot. Distributable earnings are only 20 cents per share, which is still 25% higher than 25 cents per share after reducing the distribution.

The $163 million in CECL reserves sounds impressive, but in reality it represents only 8% of loans. Four loans entered non-accrual status this quarter. At first glance, you might think that these 4 loans are all for the office sector. After all, you can find 5 non-accrual loans here.

but it is not the truth. Among the above five loans, three were in non-accrual status as of September 30, 2023.

So we had two office loans and one loan from the multifamily and industrial segment that came into non-accrual this quarter.

Our larger point is that there is more room for things to go wrong in the office space. Don’t assume the worst-case scenario is already priced in. This in itself should show you a combination of market pressures and underwriting standards.

The four largest loans here are being repaid as agreed, all due within the next 12 months. We believe the best case scenario is 1 default and the worst case scenario is 4 defaults. These numbers may sound extreme, but we’re just taking advantage of current market conditions and don’t even assume the deterioration will continue. Recent research suggests that approximately 44% of office loans are likely to default, and based on ACRE’s performance to date, we believe they will fare worse.

Building on the work of Jiang et al. (2023) We develop a framework to analyze the impact of credit risk on the solvency of US banks in a rising interest rate environment. We focus on commercial real estate (CRE) loans, which represent approximately one-quarter of general bank assets, which total approximately $2.7 trillion. Using loan-level data, we find that with rising interest rates and the adoption of hybrid working models, property values ​​have declined recently, with approximately 14% of loans and 44% of office loans appearing to be in “negative equity”, with current property values ​​being less than the future Repay the loan balance. Additionally, approximately one-third of loans and most office loans may experience severe cash flow issues and refinancing challenges.

source: SSRN

What is distributable income?

We doubt it will be like Hardaway songs, but the “baby don’t hurt me” part is the same. Investors in ACRE are suffering because they focus only on distributable earnings and ignore the GAAP picture. Yes, GAAP can be misleading, but the ability to distinguish when to tell the truth and when to lie is the key to successful investors. Here, GAAP shows you quarter after quarter of poor earnings and you ignore it. Whether you like GAAP or not, net interest margin is extremely relevant, and it’s also down 50% in 12 months.

This is where the bulls will step in. Positive spin? ACRE now owns real estate and derives income from it. We also highlighted this part above. So when ACRE was at $14, the first bull selling point was that it didn’t own real estate, which was good. But now it’s half the price, which is awesome. OK

By the way, ownership income isn’t that high either. It comes with a lot of fees.

how this came about

The current balance sheet remains too high for pressures on the office sector. This includes adjustments to CECL reserves. $625 million in equity is buffering assets of $2.27 billion.

The next 18 months will be the time when troubles will fully catalyze. That’s 18 months since this article was published, not 18 weeks, 18 days or 18 minutes. So keep the time frame in mind. At the same time, a significant amount of ACRE’s debt matured.

These are borrowed from happier times, and with updates we expect to extract a very different pound of flesh.

For the brave bulls out there, if you think office assets are cheap and want to make a bid, here’s an asset for you.

Bidding starts at $4 per square foot. 99% discount on replacement costs.

The average construction cost of a commercial office building will vary based on square footage and number of floors.average cost is $313 per square foot For a single-story office building, $562 For mid-rise buildings and $660 The price of high-rise buildings in the United States has increased due to a variety of factors, including more expensive building materials, stricter building codes and higher labor costs.

source: big renz

So there are real issues with the industry, and anyone who sticks to the pre-2020 model is likely to get into trouble. Of course, some REITs succeed, and some top buildings will lose less value than others. We won’t all be working from home. But there’s a reason ACRE’s total return (including distributions) over the past five years was negative 18%.

Well, there are actually two reasons. First, it’s mortgage REITs, which tend to be the worst performers over longer periods of time. Let’s compare with the VanEck Mortgage REIT Income ETF (MORT) to prove our point.

Of course, the second problem is that we think ACRE is still over-reliant on offices, which will affect future development. On our proprietary Kenny Loggins scale, ACRE would still face an “extreme” risk level (50%-75%) of another allocation cut.

We continue to give a sell rating.