Bottom Fishing A 13% Yield: Ares Commercial Real Estate

Summary

• Commercial real estate has fallen out of favor as a recession looms larger.
• You can earn massive double-digit yields by understanding some basic truths.
• Income exceeding expenses equals financial security.

Co-authored by Treading Softly.

I know that not everyone enjoys going to the great outdoors and hunting, fishing, hiking, or camping. Yet, even if you haven't experienced it, I'm sure you can imagine using a net to catch a large amount of fish. You understand that at times, to pull that net into your boat, you will need to grab a rope and pull it towards you with one hand and then the other: hand over fist. This technique will help you bring in the net quickly, yielding the largest amount of fish that are unable to escape.

When it comes to the market, I am an active buyer in almost every market environment. I don't try to play games and time the market. I believe that being an active participant in the market is the greatest way to unlock long-term, sustainable wealth for the average person. I also recognize that sometimes, the greatest opportunities in the market to earn massive amounts of income for decades to come originate from sectors that others are rapidly exiting, either because of fear or misunderstanding.

Today, I want to look at an opportunity that I have been buying hand over fist. I have cast my net into this sector, and I am pulling in high-quality picks that are generating double-digit yields that are entirely covered because others are fleeing the sector in fear.

Let's dive in!

ACRE: Making Lemonade

Ares Commercial Real Estate Corporation (NYSE:ACRE), yielding over 13%, reported Q3 earnings similar to what we have seen with other commercial mortgage real estate investment trusts, or mREITs. Cash flow remains healthy with distributable earnings of $0.25, including a $0.09 non-cash write-off, implying a recurring DE of $0.34/share. ACRE is achieving this level of earnings while operating at a below-average level of leverage at only 2.0x. Source.

On the other hand, there is clearly some pressure on borrowers, causing some of their loans to default. During the quarter, ACRE resolved two non-performing loans.

The first was a mixed-use property in Florida, which the borrower voluntarily signed over the deed of the property. The property is a mix of office and retail, which is cash flow positive, and on the earnings call, management stated that the cash flow being received from the property is "similar" to the cash flow they were receiving on the loan. ACRE is holding it and operating the property on an unleveraged basis. Management discussed the optionality of using the property as collateral for a loan as an option to increase liquidity or potentially be sold at a higher price in the future when conditions for real estate improve.

The other defaulted property resolved during the quarter was a short sale of a hotel property in Illinois. ACRE realized a $4.9 million loss, determining that it was better to extract their capital to invest elsewhere rather than invest the capital necessary to optimize the property for sale. This property has not paid interest since January 2023, so while the realized loss is reflected on the income statement, the impact on cash flow was already realized in Q2.

One thing that sets mortgage REITs apart from banks is that they have a variety of options to deal with defaulted mortgages. Sometimes, they can take the property and run it themselves; other times, they will opt to sell it, recognize the loss, and invest in a different property.

Management telegraphed that they expect to resolve a couple more properties in Q4, including $70 million worth of office space. When we look at the 10-Q, we can see that ACRE has been making positive progress toward managing the loans that are at their lowest risk ratings. In Q3, they had $380.4 million of loans in risk rating 4 and $82.5 million in loans in risk rating 5 for a total of approximately $463 million in loans that are at risk. Source.

This is a decrease from the $574 million in at-risk loans reported in Q2. Source.

In Q4, management expects to resolve approximately $70 million of these loans. This will go a long way towards providing a more firm outlook for the future. Until these loans are resolved, there won't be a concrete number for what the impact will be on book value. Currently, ACRE is reporting a book value of $12.62 after CECL (Current Expected Credit Loss) reserves. Before reserves, book value is $14.75. Realized losses could be higher or lower than the amount that is currently reserved for CECL. As their distressed loans are resolved, we should get a more clear picture.

The current market price, near $10/share, is pricing in much more extreme credit losses than ACRE has accounted for with CECL. How much more? With 54.8 million shares outstanding, ACRE trading $2.62 below book value creates room for $143.5 million in credit losses. This is more than twice the current CECL reserve.

This would be a much larger loss rate than ACRE has historically experienced. Q4 should help bring more clarity, reducing the loans at risk even further so we don't have to speculate on what losses might be; we will know them.

Meanwhile, management is becoming more bullish on the opportunities for new loans, noting that new loans are being written at lower loan-to-values and at higher spreads than existing loans. Last quarter, ACRE invested $69 million in loans on multifamily and self-storage properties.

Since ACRE has been operating at a lower level of leverage, it has plenty of room to leverage up when management sees an opportunity which will increase cash flow and help rebuild book value from whatever losses it realizes. We expect that ACRE will remain fairly conservative in Q4 and Q1 2024, and will look to expand more aggressively and consider leveraging up after the current properties at 4 and 5 risk levels are resolved.

ACRE is currently trading at a 20%+ discount to book value, which already reflects CECL. We're happy to buy the discount and collect our dividend while we wait for the next expansion cycle – which could start as soon as next spring.

Conclusion

The commercial real estate sector is one that many are leaving in a panic. I completely understand why so many are doing so. Commercial real estate loans that are originated by financial institutions like banks or credit unions are more likely to be simply foreclosed upon and the property sold, fire sale, at auction for the bank to recover some of its investment back. ACRE is not one of those institutions. It originates a completely different type of loan tied to the same sector; because of this, they have been able not only to see excellent returns in a sector where others are failing but are also more nimble and able to adapt to the prevailing winds of the market. There's a famous Douglas Adams quote that says, "Ships hung in the sky in much the same way that bricks don't." In the commercial real estate sector, ACRE is defying expectations through exceptional management.

When it comes to retirement, the last thing you want to have to worry about is keeping up with the crowd. One of the biggest financial mistakes that so many make is trying to keep up with the perceived wealth of the others around them – it's the concept of "keeping up with the Joneses." Your retirement is going to be wholly unique to you. Your financial needs and expectations, while they may be similar to others, are going to be unique when they come tailored to what you want to do with your retirement and your personal desires and experiences. Often, the answer, however, can be similar – you're going to need income to pay for all of that, whether you need a lot of income to pay for a grandiose retirement or a little income to pay for a more modest one. I don't want you to have to pinch pennies and scrimp on your retirement because of your financial planning. I want you to have financial success and financial security. That's something that my Income Method can provide.

That's the beauty of my Income Method. That's the beauty of income investing.