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ACRE > SEC Filings for ACRE > Form 10-Q on 7-May-2014All Recent SEC Filings

Show all filings for ARES COMMERCIAL REAL ESTATE CORP

Form 10-Q for ARES COMMERCIAL REAL ESTATE CORP


7-May-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Some of the statements contained in this quarterly report constitute forward looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities and Exchange Act of 1934, as amended, and we intend such statements to be covered by the safe harbor provisions contained therein. The information contained in this section should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this quarterly report on Form 10-Q. This description contains forward-looking statements that involve risks and uncertainties. Actual results could differ significantly from the results discussed in the forward-looking statements due to the factors set forth in "Risk Factors" and elsewhere in this quarterly report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. In addition, some of the statements in this quarterly report (including in the following discussion) constitute forward-looking statements, which relate to future events or the future performance or financial condition of Ares Commercial Real Estate Corporation (except where the context suggests otherwise, together with our consolidated subsidiaries, the "Company," "ACRE," "we," "us," or "our"). The forward-looking statements contained in this quarterly report involve a number of risks and uncertainties, including statements concerning:

          our business and investment strategy;



          our projected operating results;



          the timing of cash flows, if any, from our investments;



          the state of the U.S. economy generally or in specific geographic
regions;



          defaults by borrowers in paying debt service on outstanding items;



          actions and initiatives of the U.S. Government and changes to U.S.
Government policies;



          our ability to obtain financing arrangements;



          the amount of commercial mortgage loans requiring refinancing;



          financing and advance rates for our target investments;



          our expected leverage;



          general volatility of the securities markets in which we may invest;



          the impact of a protracted decline in the liquidity of credit markets
on our business;



          the uncertainty surrounding the strength of the U.S. economic
recovery;



          the return or impact of current and future investments;



          allocation of investment opportunities to us by Ares Commercial Real
Estate Management LLC, or "our Manager";



          changes in interest rates and the market value of our investments;



          effects of hedging instruments on our target investments;



          rates of default or decreased recovery rates on our target
investments;



          the degree to which our hedging strategies may or may not protect us
from interest rate volatility;



          changes in governmental regulations, tax law and rates, and similar
matters (including interpretation thereof);



          our ability to maintain our qualification as a real estate investment

trust for U.S. federal income tax purposes, or "REIT";


our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended, or the "1940 Act";

availability of investment opportunities in mortgage-related and real estate-related investments and securities;

the ability of our Manager to locate suitable investments for us, monitor, service and administer our investments and execute our investment strategy;

          our ability to successfully complete and integrate any acquisitions;



          our ability to integrate ACRE Capital LLC into our business and
achieve the benefits we anticipate from our acquisition of ACRE Capital LLC;



          the successful completion of the ACRE Capital LLC restructuring and
relocation;



          availability of qualified personnel;



          estimates relating to our ability to make distributions to our
stockholders in the future;



          our understanding of our competition;



          market trends in our industry, interest rates, real estate values,
the debt securities markets or the general economy; and



          the future of U.S. Government-sponsored entities.

We use words such as "anticipates," "believes," "expects," "intends," "will," "should," "may" and similar expressions to identify forward-looking statements. Our actual results could differ materially from those expressed in the forward-looking statements for any reason, including the factors set forth in "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 and elsewhere in this quarterly report on Form 10-Q.

We have based the forward-looking statements included in this quarterly report on Form 10-Q on information available to us on the date of this quarterly report on Form 10-Q, and we assume no obligation to update any such forward-looking statements.

Overview

We are a specialty finance company that operates both as a principal lender and a mortgage banker (with respect to loans collateralized by multifamily and senior-living properties). We are externally managed by our Manager or "ACREM," a wholly owned subsidiary of Ares Management LLC, or "Ares Management," a global alternative asset manager and a SEC registered investment adviser, pursuant to the terms of a management agreement. Our Manager has investment professionals strategically located across the nation who directly source new loan opportunities for us with owners, operators and sponsors of commercial real estate ("CRE") properties. From the commencement of our operations in late 2011, we have been primarily focused on our principal lending business, where we directly originate, manage and service a diversified portfolio of CRE debt-related investments for our own account.

We are also engaged in the mortgage banking business through our wholly owned subsidiary, ACRE Capital LLC ("ACRE Capital"), which we believe is complementary to our principal lending business. In this business segment, we primarily originate, sell and service multifamily and other senior-living-related loans under programs offered by Fannie Mae ("Fannie Mae") and the Federal Housing Administration, a division of the U.S. Department of Housing and Urban Development ("HUD"). ACRE Capital is approved as a Delegated Underwriting and Servicing ("DUS") lender to Fannie Mae, a Multifamily Accelerated Processing ("MAP") and Section 232 LEAN lender for HUD, and a Government National Mortgage Association ("Ginnie Mae") issuer. While we earn little interest income from these activities as we generally only hold loans for short periods, we receive origination fees when we close loans and sale premiums when we sell loans. We also retain the rights to service the loans, which are known as mortgage servicing rights or "MSRs" and receive fees for providing such service during the life of the loans which generally last ten years or more.

Because we operate both as a principal lender and a mortgage banker (with respect to loans collateralized by multifamily and senior-living properties), we can offer a wider array of financing solutions to our customers, including
(i) short and long-term loans ranging from one to ten (or more) years,
(ii) bridge and permanent loans, (iii) floating and fixed rate loans, and
(iv) loans


collateralized by development, value-add (or transitional) and stabilized properties. We also have the flexibility to provide a combination of solutions to our customers, including instances where our principal lending business provides a short-term, bridge loan to an owner of multifamily properties while our mortgage banking business seeks long-term permanent financing for the same customer. This provides us the opportunity to offer a customer an efficient "one stop" financial product and at the same time to earn revenues at multiple times in the relationship with the customer. First, we earn interest and interest-related income while holding the short term bridge loan. Second, we earn origination fees and sale premiums when we provide permanent financing and sell the loans under HUD/Ginnie Mae and government sponsored entity ("GSE") programs. And, third, we earn servicing fees from MSRs that we retain on the permanent loans.

We were formed and commenced operations in late 2011. We are a Maryland corporation and completed our initial public offering (the "IPO") in May 2012. We have elected and qualified to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, commencing with our taxable year ended December 31, 2012. We generally will not be subject to U.S. federal income taxes on our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains, to the extent that we annually distribute all of our REIT taxable income to stockholders and comply with various other requirements as a REIT. We also operate our business in a manner that will permit us to maintain our exemption from registration under the 1940 Act.

We are an "emerging growth company," as defined in the Jumpstart Our Business Startups Act of 2012, or the "JOBS Act," and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not "emerging growth companies." In addition,
Section 107 of the JOBS Act also provides that an "emerging growth company" can take advantage of the extended transition period provided in
Section 7(a)(2)(B) of the Securities Act of 1933, as amended, for complying with new or revised accounting standards. However, we chose to "opt out" of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

We could remain an "emerging growth company" for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1.0 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1.0 billion in non-convertible debt during the preceding three year period.

The results of our operations are affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, commercial mortgage loans, CRE debt and other financial assets in the marketplace. Our net interest income, which reflects the amortization of origination fees and direct costs, is recognized based on the contractual rate and the outstanding principal balance of the loans we originate. Interest rates will vary according to the type of investment, conditions in the financial markets, credit worthiness of our borrowers, competition and other factors, none of which can be predicted with any certainty. Our operating results may also be impacted by credit losses in excess of initial anticipations or unanticipated credit events experienced by borrowers.

Changes in Fair Value of Our Assets. In our principal lending business, we generally hold our target investments as long-term investments. We evaluate our investments for impairment on at least a quarterly basis and impairments will be recognized when it is probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, we will record an allowance to reduce the carrying value of the loan to the present value of expected future cash flows discounted at the loan's contractual effective rate, or if repayment is expected solely from the collateral, the fair value of the collateral.

Loans are collateralized by real estate and as a result, the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower, are regularly evaluated. We monitor performance of our investment portfolio under the following methodology: (1) borrower review, which analyzes the borrower's ability to execute on its original business plan, reviews its financial condition, assesses pending litigation and considers its general level of responsiveness and cooperation; (2) economic review, which considers underlying collateral, i.e., leasing performance, unit sales and cash flow of the collateral and its ability to cover debt service as well as the residual loan balance at maturity; (3) property review, which considers current environmental risks, changes in insurance costs or coverage, current site visibility, capital expenditures and market perception; and (4) market review, which analyzes the collateral from a supply and demand perspective of similar property types, as well as from a capital markets perspective. Such impairment analyses are completed and reviewed by asset management and finance personnel who utilize various data sources, including periodic financial data such as property occupancy, tenant profile, rental rates, operating expenses, and the borrower's exit plan, among other factors.


As of March 31, 2014 and December 31, 2013, all loans were paying in accordance with their terms. There were no impairments during the three months ended March 31, 2014 and 2013.

Although we generally hold our target investments as long-term investments within our principal lending business, we may occasionally classify some of our investments as available-for-sale; provided that such classification would not jeopardize our ability to maintain our qualification as a REIT. Investments classified as available-for-sale will be carried at their fair value, with changes in fair value recorded through accumulated other comprehensive income, a component of stockholders' equity, rather than through earnings. Additionally, ACRE Capital originates multifamily mortgage loans, which are recorded at fair value. The holding period for these loans held for sale is approximately 30 days. At this time, we do not expect to hold any of our investments for trading purposes.

Changes in Market Interest Rates. With respect to our business operations, increases in interest rates, in general, may over time cause:

the interest expense associated with our borrowings to increase, subject to any applicable ceilings;



          the value of our mortgage loans to decline;



          coupons on our mortgage loans to reset to higher interest rates; and



          to the extent we enter into interest rate swap agreements as part of

our hedging strategy where we pay fixed and receive floating interest rates, the value of these agreements to increase.

Conversely, decreases in interest rates, in general, may over time cause:

the interest expense associated with our borrowings to decrease, subject to any applicable floors;

the value of our mortgage loan portfolio to increase, for such mortgages with applicable floors;

coupons on our floating rate mortgage loans to reset to lower interest rates; and

to the extent we enter into interest rate swap agreements as part of our hedging strategy where we pay fixed and receive floating interest rates, the value of these agreements to decrease.

Credit Risk. We are subject to varying degrees of credit risk in connection with our target investments. Our Manager seeks to mitigate this risk by seeking to originate or acquire investments of higher quality at appropriate prices given anticipated and unanticipated losses, by employing a comprehensive review and selection process and by proactively monitoring originated or acquired investments. Nevertheless, unanticipated credit losses could occur that could adversely impact our operating results and stockholders' equity.

Market Conditions. We believe that our target investments currently present attractive risk-adjusted return profiles, given the underlying property fundamentals and the competitive landscape for the type of capital we provide. Following a dramatic decline in CRE lending in 2008 and 2009, debt capital has become more readily available for select stabilized, high quality assets in certain locations such as gateway cities, but remains muted for many other types of properties, either because of the markets in which they are located or because the property is undergoing some form of value creation transition. More particularly, the available financing products tend to come with limited flexibility, especially with respect to prepayment. Consequently, we anticipate a high demand for the type of customized debt financing we provide from borrowers or sponsors who are looking to refinance indebtedness that is maturing in the next two to five years or are seeking shorter-term debt solutions as they reposition their properties. We also envision that demand for financing will be strong for situations in which a property is being acquired with plans to improve the net operating income through capital improvements, leasing, costs savings or other key initiatives and realize the improved value through a subsequent sale or refinancing. We also see a changing landscape in which many historical debt capital providers respond to banking regulatory reform with less active participation or more rigid products, less tailored to the needs of the borrowing community. While we expect to see or have seen the emergence of new providers, we believe those with deep experience and strong backing will have the opportunity to build market share.

Performance of Multifamily and Other Commercial Real Estate Related Markets. Our business is dependent on the general demand for, and value of, commercial real estate and related services, which are sensitive to economic conditions. Demand for multifamily and other commercial real estate generally increases during periods of stronger economic conditions, resulting in increased property values, transaction volumes and loan origination volumes. During periods of weaker economic conditions,


multifamily and other commercial real estate may experience higher property vacancies, lower demand and reduced values. These conditions can result in lower property transaction volumes and loan originations, as well as an increased level of servicer advances and losses from ACRE Capital's Fannie Mae DUS allowance for loss sharing.

The Level of Losses from Fannie Mae Allowance for Loss Sharing. Loans originated and sold by ACRE Capital to Fannie Mae under the Fannie Mae DUS program are subject to the terms and conditions of a Master Loss Sharing Agreement, which was amended and restated during 2012. Under the Master Loss Sharing Agreement, ACRE Capital is responsible for absorbing certain losses incurred by Fannie Mae with respect to loans originated under the DUS program, as described below in more detail.

The losses incurred with respect to individual loans are allocated between ACRE Capital and Fannie Mae based on the loss level designation ("Loss Level") for the particular loan. Loans are designated as Loss Level I, Loss Level II or Loss Level III. All loans are designated Loss Level I unless Fannie Mae and ACRE Capital agree upon a different Loss Level for a particular loan at the time of the loan commitment, or if Fannie Mae determines that the loan was not underwritten, processed or serviced according to Fannie Mae guidelines.

Losses on Loss Level I loans are shared 33.33% by ACRE Capital and 66.67% by Fannie Mae. The maximum amount of ACRE Capital's risk-sharing obligation with respect to any Loss Level I loan is 33.33% of the original principal amount of the loan. Losses incurred in connection with Loss Level II and Loss Level III loans are allocated disproportionately to ACRE Capital until ACRE Capital has absorbed the maximum level of its risk-sharing obligation with respect to the particular loan. The maximum loss allocable to ACRE Capital for Loss Level II loans is 30% of the original principal amount of the loan, and for Loss Level III loans is 40% of the original principal amount of the loan.

The Price of Loans in the Secondary Market. Our profitability is determined in part by the price we are paid for the loans we originate. A component of our origination fees is the premium we recognize on the sale of a loan. Stronger investor demand typically results in larger premiums while weaker demand results in little to no premium.

Market for Servicing Commercial Real Estate Loans. Service fee rates for new loans are set at the time we enter into a loan commitment based on origination volumes, competition and prepayment rates. Changes in future service fee rates impact the value of our future MSRs and future servicing revenues, which could impact our profit margins and operating results over time.

Restructuring activities

During the three months ended March 31, 2014, we began restructuring and relocating certain ACRE Capital support services in order to centralize the platform into one location. For the three months ended March 31, 2014, we recorded $0.2 million of costs associated with restructuring activities, which consisted primarily of employee termination costs. These costs were recorded in general and administrative expenses within the ACRE Capital operating segment.

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with GAAP, which require management to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and other factors management believes to be reasonable. Actual results may differ from those estimates and assumptions. There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

Results of Operations

The following table sets forth consolidated results of operations for the three months ended March 31, 2014 and 2013 ($ in thousands):


                                                 For the three months ended March 31,

                                                      2014                    2013


Net interest margin:

Interest income from loans held for
investment                                     $            15,152      $           6,711

Interest expense                                           (5,072)                (1,385)

Net interest margin                                         10,080                  5,326


Mortgage banking revenue:

Servicing fees, net                                          5,263                      -

Gains from mortgage banking activities                       1,386                      -

Provision for loss sharing                                   (119)                      -

Change in fair value of mortgage servicing
rights                                                     (1,847)                      -

Mortgage banking revenue                                     4,683                      -


Gain on sale of loans                                          680                      -

Total revenue                                               15,443                  5,326


Expenses:

Other interest expense                                       1,685                  1,552

Management fees to affiliate                                 1,492                    614

Professional fees                                              925                    566

Compensation and benefits                                    4,021                      -

Acquisition and investment pursuit costs                        20                    640

General and administrative expenses                          2,219                    482

General and administrative expenses
reimbursed to affiliate                                      1,000                    747

Total expenses                                              11,362                  4,601

Changes in fair value of derivatives                             -                  (398)

Income from operations before income taxes                   4,081                    327

Income tax expense (benefit)                                 (674)                      -

Net income                                     $             4,755      $             327

Comparison of Three Months Ended March 31, 2014 and 2013

Net Interest Margin

For the three months ended March 31, 2014 and 2013, we earned approximately $10.1 million and $5.3 million in net interest margin, respectively. For the three months ended March 31, 2014 and 2013, interest income from loans held for investment of $15.2 million and $6.7 million, respectively, was generated by weighted average earning assets of $1.1 billion and $358.0 million, respectively, offset by $5.1 million and $1.4 million, respectively, of interest expense, unused fees and amortization of deferred loan costs. The weighted average borrowings under our secured funding agreements were $702.5 million and $149.6 million for the three months ended March 31, 2014 and 2013, respectively. The increase in net interest margin for the three months ended March 31, 2014 compared to the three months ended March 31, 2013 primarily relates to the increase in the number of loans held for investment from 17 loans to 39 loans as of March 31, 2014.

Mortgage Banking Revenue

For the three months ended March 31, 2014, we earned approximately $5.3 million in net servicing fees. Servicing fees include fees earned for all activities related to servicing ACRE Capital's loans, the fees earned on borrower prepayment penalties and interest earned on borrowers' escrow payments and interim cash balances, along with other ancillary fees. For the three months ended March 31, 2014, we earned approximately $1.4 million in net gains from mortgage banking activities. Gains from mortgage banking activities includes the initial fair value of MSRs, loan origination fees, gain on the sale of loans, interest income on loans held for sale and changes to the fair value of derivative financial instruments, including loan commitments and forward sale commitments. Since the acquisition of ACRE Capital closed on August 30, 2013, we did not earn any servicing fees or have gains from mortgage banking activities for the three months ended March 31, 2013 relating to ACRE Capital.


Operating Expenses

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