Ares mercial Real Estate (ACRE) - 2022 Q4 - Annual Report

Part I Item 1. Business Ares Commercial Real Estate Corporation (ACRE) is a specialty finance REIT focused on originating and investing in diversified commercial real estate (CRE) loans, externally managed by Ares Commercial Real Estate Management LLC - ACRE is a specialty finance company, externally managed by ACREM, a subsidiary of Ares Management, focusing on originating and investing in CRE loans and related investments, and has elected to be taxed as a REIT[13][14] - The company's investment strategy centers on direct origination of customized financing solutions for borrowers with value-improving business plans, who often face challenges in securing capital from traditional bank and capital market sources[15][17] Target Asset Classes | Asset Type | Description | | :--- | :--- | | Senior Mortgage Loans | Typically first liens on various commercial properties, may include A-Notes and B-Notes | | Subordinated Debt | Includes structurally subordinated first mortgage loans and junior participations (e.g., B-Notes) | | Mezzanine Loans | Subordinated loans secured by a pledge of the borrower's equity in the property-owning entity | | Preferred Equity | Subordinate to first mortgage loans, not collateralized by the property, but with covenants to protect the investment | | Other CRE Investments | Includes CMBS, loans to real estate companies, and other income-producing equity investments | - ACRE's financing strategy utilizes prudent leverage, with a target debt-to-equity ratio not exceeding 4.5-to-1; primary financing sources include credit facilities, securitizations, and public or private offerings of equity or debt[31][32] Financing and Securitization Balances as of Dec 31, 2022 | Financing Type | Outstanding Balance ($) | | :--- | :--- | | Financing Agreements | $960.2 million | | CLO Securitizations | $779.0 million | - The company operates in a highly competitive market, competing with other REITs, specialty finance companies, banks, and institutional investors, leveraging its Manager's industry expertise as a competitive advantage[39][41] Item 1A. Risk Factors The company faces a wide range of risks that could materially affect its business, financial condition, and results of operations Risks Related to Our Business The company's business is exposed to significant macroeconomic risks, including global economic slowdowns, recessions, and declines in real estate values, which could impair investments - A global economic slowdown, recession, or declining real estate values could severely impair investments, increase the CECL Reserve, and trigger margin calls on financing agreements; the CECL Reserve increased from $25.2 million in 2021 to $71.3 million in 2022 due to macroeconomic pressures[48][57][58] - Rising interest rates, while potentially beneficial for a portfolio of 99% floating-rate loans, could strain borrowers' ability to make debt service payments, leading to non-performance or default[59][60] - The transition away from LIBOR, set to cease after June 30, 2023, poses risks as the company held $1.2 billion in LIBOR-based loans and $1.1 billion in LIBOR-based debt with maturities beyond this date as of December 31, 2022, creating potential mismatches and adverse effects on operating results[68][71] - The business could be adversely affected by health pandemics, such as COVID-19, which can impact industries whose properties serve as collateral for the company's loan portfolio, potentially leading to borrower defaults[73][74] Risks Related to Sources of Financing and Hedging The company's use of significant debt exposes it to increased risk of loss, with substantial outstanding balances under financing agreements and CLO securitizations - The company may incur significant debt, which increases the risk of loss; as of December 31, 2022, ACRE had $960.2 million outstanding under Financing Agreements and $779.0 million under CLO Securitizations[75][76] - Financing agreements impose restrictive covenants that can limit the ability to incur additional debt, make certain investments, and distribute income to stockholders, with failure to comply potentially leading to default and acceleration of debt[80] - Financing facilities may require the company to provide additional collateral or pay down debt if the value of pledged assets declines, which could reduce liquidity and force asset sales at unfavorable times[87][88] - Access to financing is dependent on market conditions, and an inability to access capital markets could limit business growth and the ability to fund new investments[90][92] - Hedging activities, while intended to reduce interest rate risk, can be expensive, may not be perfectly effective, and expose the company to counterparty credit risk[102][103] Risks Related to Our Investments The company's investments carry inherent risks, including illiquidity, concentration, and higher loss potential for specialized loan types - The company's investments, particularly senior mortgage loans, subordinated debt, and mezzanine loans, are illiquid, which may make it difficult to sell them quickly without realizing significant losses, especially during turbulent market conditions[117] - The investment portfolio is concentrated, with 60 loans held for investment as of December 31, 2022, making it vulnerable to poor performance by a small number of these loans that could significantly impact aggregate returns[118] - CRE loans are subject to delinquency and foreclosure risks, dependent on the property's net operating income, which can be affected by tenant mix, property condition, competition, and economic conditions[123][124] - Mezzanine loans and preferred equity investments involve greater risk of loss than senior loans because they are subordinate and may not be fully secured by the underlying real estate, potentially leading to a complete loss of investment in a default scenario[143][145] - Construction loans carry increased risks, including cost overruns, non-completion, and the borrower's inability to secure permanent financing, which could result in significant losses[139][167] Risks Related to Our Common Stock The market price of ACRE's common stock is subject to significant fluctuation due to various factors, and future equity issuances could dilute stockholder interests - The market price of the company's common stock (NYSE: ACRE) is subject to significant volatility from factors including operating results, changes in interest rates, equity issuances, and general market conditions[171][172] - Future sales of common stock could have an adverse effect on the share price; in 2021 and 2022, the company sold a total of 20.5 million shares in three underwritten offerings and sold 190,369 shares under its 'At the Market' program in 2022[175][176] - The company has not set a minimum distribution level, and its ability to make distributions, required to maintain REIT status, depends on earnings, financial condition, and debt covenants, with no assurance they can be maintained[176][177] Risks Related to Our Organization and Structure The company's organizational structure and Maryland corporate law present risks, including potential acquisition deterrence and operational limits from maintaining Investment Company Act exemption - Maryland's General Corporation Law (MGCL) prohibits certain business combinations with 'interested stockholders' (owners of 10% or more), which may deter or make acquisitions of the company more difficult[184][185] - The company's charter authorizes the issuance of up to 450 million common and 50 million preferred shares without stockholder approval, which could be used to prevent a change in control[190] - Maintaining exemption from registration under the Investment Company Act of 1940 imposes significant operational limits, with subsidiaries often relying on Section 3(c)(5)(C), requiring at least 55% of assets to be 'qualifying real estate assets' and at least 80% to be real estate-related, which restricts investment flexibility[191][196] - To preserve its REIT qualification, the company's charter generally prohibits any person from owning more than 9.8% of its outstanding stock, which could discourage takeovers or transactions that might offer a premium to stockholders[211] Risks Related to Our Relationship with Our Manager and Its Affiliates ACRE is highly dependent on its external manager, ACREM, which presents potential conflicts of interest and a fee structure that may not fully align with stockholder interests - The company is completely reliant on its Manager, ACREM, for day-to-day operations and investment advisory services, as it has no employees of its own[212] - Significant conflicts of interest exist because Ares Management affiliates manage other investment vehicles that may compete for the same assets, with investment opportunities allocated based on an internal policy, and no guarantee ACRE will participate in all suitable investments[218][219] - The Management Agreement was not negotiated at arm's-length; the base management fee is calculated as 1.5% of stockholders' equity, which may incentivize the Manager to increase equity rather than maximize risk-adjusted returns[227][228] - Terminating the Management Agreement without cause is difficult and requires payment of a termination fee equal to three times the sum of the average annual base management fee and incentive fee during the prior 24-month period[230] - The incentive fee, based on 'Core Earnings', may encourage the Manager to select riskier assets to increase its compensation; for 2022, the incentive fee incurred was $3.4 million[231][232] United States Federal Income Tax Risks Maintaining REIT status is critical and subject to complex tax rules, with failure resulting in corporate-level income tax and distribution requirements potentially forcing unfavorable asset sales - Failure to maintain REIT qualification would subject the company to U.S. federal income tax at corporate rates and disqualify it from REIT status for four subsequent taxable years, severely impacting operations[247][251] - The requirement to distribute at least 90% of REIT taxable income annually may force the company to borrow funds or sell assets, potentially at unfavorable times, to meet distribution requirements[254][255] - The company's use of Taxable REIT Subsidiaries (TRSs) is limited, as securities of TRSs cannot exceed 20% of the gross value of its assets, and transactions between the REIT and its TRSs that are not at arm's-length are subject to a 100% excise tax[261][262] - Securitization activities can create a taxable mortgage pool (TMP), resulting in 'excess inclusion income' that may be subject to increased taxes for certain stockholders (e.g., non-U.S. stockholders, tax-exempt entities)[274] General Risk Factors The company is subject to general business risks, including changes in laws and regulations, cybersecurity threats, and increasing scrutiny of ESG activities - Changes in laws or regulations, such as the Dodd-Frank Act, could negatively impact operations, increase costs, and affect the availability and cost of financing from lenders[287][288] - The company faces significant cybersecurity risks from potential breaches that could disrupt operations, compromise confidential data, and lead to financial loss, litigation, and reputational damage[294][295] - There is increasing public, investor, and regulatory scrutiny of Environmental, Social, and Governance (ESG) activities, where failure to act responsibly could damage the company's brand and relationships with investors[301][302] Item 1B. Unresolved Staff Comments The company reports that it has no unresolved staff comments from the SEC - None[304] Item 2. Properties The company's principal executive offices are located in New York, NY, and are leased by its Manager, with ACRE reimbursing a pro-rata portion of expenses - The principal executive offices are located in New York, NY, and are leased by the Manager or an affiliate; ACRE reimburses the Manager for its pro-rata share of rent and other office expenses as per the Management Agreement[305] Item 3. Legal Proceedings As of December 31, 2022, the company was not subject to any material pending legal proceedings - As of December 31, 2022, the company was not involved in any material pending legal proceedings[306] Item 4. Mine Safety Disclosures This item is not applicable to the company - Not applicable[307] Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities ACRE's common stock is traded on the NYSE, and the company maintains a distribution policy consistent with REIT status, with a $50 million stock repurchase program approved in July 2022 - The company's common stock is listed on the New York Stock Exchange (NYSE) under the trading symbol 'ACRE'[309] - To maintain its REIT status, the company is generally required to distribute at least 90% of its REIT taxable income annually; for the years 2022, 2021, and 2020, the company accrued excise tax of $430 thousand, $272 thousand, and $369 thousand, respectively, for undistributed income[311] - On July 26, 2022, the Board of Directors approved a stock repurchase program for up to $50 million of common stock, effective until July 26, 2023, with the full amount remaining available as of December 31, 2022[319] Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations In 2022, ACRE's net income decreased to $29.8 million, primarily due to a significant increase in the provision for current expected credit losses, despite growth in net interest margin Investment Portfolio Analysis As of December 31, 2022, the company's investment portfolio consisted of 60 loans with an outstanding principal of $2.3 billion, predominantly senior mortgage loans with a weighted average remaining life of 1.4 years Loans Held for Investment Portfolio as of Dec 31, 2022 | Loan Type | Carrying Amount ($ thousands) | Outstanding Principal ($ thousands) | Weighted Avg. Unleveraged Effective Yield | Weighted Avg. Remaining Life (Years) | | :--- | :--- | :--- | :--- | :--- | | Senior mortgage loans | $2,225,725 | $2,243,818 | 8.4% | 1.3 | | Subordinated debt and preferred equity | $38,283 | $39,003 | 14.0% | 2.8 | | Total Portfolio | $2,264,008 | $2,282,821 | 8.5% | 1.4 | - As of December 31, 2022, the portfolio included 60 loans held for investment; during the year, the company funded approximately $676.9 million of outstanding principal and received repayments of $823.2 million[346] - As of December 31, 2022, three loans with a carrying value of $99.1 million were on non-accrual status, compared to two loans with a carrying value of $45.0 million at year-end 2021[336] Critical Accounting Estimates The Current Expected Credit Loss (CECL) Reserve is the most significant accounting estimate, requiring substantial judgment regarding historical loss data, loan repayment timing, and macroeconomic forecasts - The company adopted the CECL methodology, which requires estimating expected credit losses based on historical experience adjusted for current and future conditions; the CECL Reserve is recorded as a valuation account against loans held for investment and as a liability for unfunded commitments[351] - Estimating the CECL Reserve involves significant judgment regarding historical loan loss data, expected loan repayments, default probabilities, and the macroeconomic outlook, utilizing historical market loan loss data from a third-party service for its estimates[352] Results of Operations For 2022, net income attributable to common stockholders significantly decreased to $29.8 million from $60.5 million in 2021, primarily due to a substantial increase in the provision for current expected credit losses Consolidated Results of Operations Summary ($ in thousands) | Metric | 2022 | 2021 | | :--- | :--- | :--- | | Total Revenue | $106,849 | $102,069 | | Total Expenses | $32,728 | $40,877 | | Provision for credit losses | $46,061 | $10 | | Gain on sale of REO | $2,197 | $— | | Net Income | $29,785 | $60,460 | - Net interest margin increased by 25% to $104.2 million in 2022 from $83.6 million in 2021, primarily due to a larger portfolio of earning assets and the benefit of rising LIBOR and SOFR rates[359][360] - The provision for current expected credit losses increased dramatically to $46.1 million in 2022 from $10 thousand in 2021, mainly due to new loan production and the negative impact of the macroeconomic environment, including rising inflation and interest rates[368] - Related party expenses, primarily management and incentive fees paid to the Manager, increased to $14.9 million in 2022 from $12.1 million in 2021, driven by higher average stockholders' equity and Core Earnings[363] - Expenses from real estate owned decreased to $4.3 million in 2022 from $18.5 million in 2021, as the hotel property was sold on March 1, 2022[362][367] Liquidity and Capital Resources The company's primary liquidity sources include unused borrowing capacity, equity offering proceeds, and investment portfolio cash flow, with total liquidity at approximately $216 million as of February 14, 2023 - As of February 14, 2023, the company had approximately $216 million in liquidity, consisting of $141 million in unrestricted cash and $75 million of availability under its Secured Funding Agreements[379] - In May 2022, the company closed a public offering of 7 million shares of common stock, generating net proceeds of approximately $103.2 million[381] Summary of Financing Agreements as of Dec 31, 2022 ($ in thousands) | Facility Type | Total Commitment ($ thousands) | Outstanding Balance ($ thousands) | | :--- | :--- | :--- | | Secured Funding Agreements | $1,280,000 | $705,231 | | Notes Payable | $105,000 | $105,000 | | Secured Term Loan | $150,000 | $150,000 | | Total | $1,535,000 | $960,231 | Cash Flow Summary ($ in thousands) | Activity | 2022 | 2021 | | :--- | :--- | :--- | | Net cash from operating activities | $57,157 | $48,350 | | Net cash from (used in) investing activities | $193,173 | $(699,685) | | Net cash (used in) from financing activities | $(159,667) | $627,174 | | Change in cash | $90,663 | $(24,161) | Item 7A. Quantitative and Qualitative Disclosures About Market Risk The company actively manages credit, interest rate, market, and financing risks, with interest rate risk mitigated by matching floating-rate assets with liabilities and using derivatives - The company is exposed to credit risk from its CRE loans, managed through comprehensive due diligence and ongoing portfolio review, though the current macroeconomic environment may increase borrower defaults[404][405] - Interest rate risk is primarily managed by originating floating-rate assets financed with index-matched floating-rate liabilities, and the company also uses hedging instruments like interest rate swaps to mitigate exposure[406] Hypothetical Interest Rate Effect on Net Income ($ in millions) | Change in 30-Day LIBOR or SOFR | Increase/(Decrease) in Net Income ($ millions) | | :--- | :--- | | Up 100 basis points | $10.1 | | Up 50 basis points | $5.0 | | LIBOR or SOFR at 0 basis points | $(26.3) | - Financing risk stems from borrowings, which contain margin call provisions and restrictive covenants, and weakness in financial markets could affect lenders' willingness to provide financing[413] Item 9A. Controls and Procedures Management concluded that the company's disclosure controls and procedures and internal control over financial reporting were effective as of December 31, 2022 - Management concluded that the company's disclosure controls and procedures were effective as of December 31, 2022[418] - Management concluded that the company's internal control over financial reporting was effective as of December 31, 2022, based on the COSO framework, with the independent auditor, Ernst & Young LLP, concurring with this assessment[421] - No material changes were made to the company's internal control over financial reporting during the fourth quarter of 2022[422] Item 9B. Other Information This section includes a disclosure regarding an affiliate's terminated contract with a designated entity and the adoption of amended bylaws to update stockholder nomination procedures - A disclosure was made regarding an affiliate's investment in Daisy Group Limited, which had a contract with Melli Bank Plc; this contract generated minimal revenue and was terminated on February 26, 2022[425][426] - On February 15, 2023, the Board of Directors adopted Second Amended and Restated Bylaws, primarily to align stockholder nomination procedures with the SEC's new universal proxy rules (Rule 14a-19)[427] Part III Item 10. Directors, Executive Officers and Corporate Governance Information concerning directors, executive officers, and corporate governance is incorporated by reference from the company's 2023 Proxy Statement - Information is incorporated by reference from the Company's 2023 Proxy Statement[433] Item 11. Executive Compensation Information concerning executive compensation is incorporated by reference from the company's 2023 Proxy Statement - Information is incorporated by reference from the Company's 2023 Proxy Statement[434] Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The company provides details on its equity compensation plan, with 901,060 shares remaining available for future issuance as of December 31, 2022 - The company's Amended and Restated 2012 Equity Incentive Plan was amended in May 2022 to increase the total number of shares available for grant to 2,490,000[436] Equity Compensation Plan Information as of Dec 31, 2022 | Plan Category | Number of securities to be issued upon exercise | Weighted-average exercise price | Number of securities remaining available for future issuance | | :--- | :--- | :--- | :--- | | Equity compensation plans approved by stockholders | — | $ — | 901,060 | | Total | — | $ — | 901,060 | Item 13. Certain Relationships and Related Party Transactions, and Director Independence Information concerning related party transactions and director independence is incorporated by reference from the company's 2023 Proxy Statement - Information is incorporated by reference from the Company's 2023 Proxy Statement[440] Item 14. Principal Accountant Fees and Services Information concerning principal accountant fees and services is incorporated by reference from the company's 2023 Proxy Statement - Information is incorporated by reference from the Company's 2023 Proxy Statement[441] Part IV Item 15. Exhibits and Financial Statement Schedules This section lists the documents filed as part of the annual report, including financial statements and various exhibits, with financial statement schedules omitted as not required - This section provides an index of all exhibits filed with the Form 10-K, including corporate governance documents, financing agreements, the management agreement, and executive certifications[443][444] Item 16. Form 10-K Summary No Form 10-K summary is provided - None[455] Financial Statements and Supplementary Data Report of Independent Registered Public Accounting Firm Ernst & Young LLP issued an unqualified opinion on the company's consolidated financial statements and internal control over financial reporting, identifying the CECL Reserve as a critical audit matter - Ernst & Young LLP provided an unqualified opinion on both the consolidated financial statements and the effectiveness of internal control over financial reporting as of December 31, 2022[459][466] - The estimation of the Current Expected Credit Loss (CECL) Reserve was identified as a critical audit matter because it involved especially challenging, subjective, or complex judgments regarding historical loss data, loan repayment timing, and macroeconomic forecasts[470][473] Consolidated Financial Statements The consolidated financial statements show a decrease in total assets and liabilities, an increase in stockholders' equity, and a significant decline in net income for 2022 Consolidated Balance Sheet Summary ($ in thousands) | Account | Dec 31, 2022 | Dec 31, 2021 | | :--- | :--- | :--- | | Loans held for investment, net | $2,198,039 | $2,390,444 | | Total Assets | $2,523,002 | $2,631,838 | | Total Liabilities | $1,775,462 | $1,953,210 | | Total Stockholders' Equity | $747,540 | $678,628 | Consolidated Statement of Operations Summary ($ in thousands) | Account | 2022 | 2021 | 2020 | | :--- | :--- | :--- | :--- | | Net Interest Margin | $104,177 | $83,551 | $69,103 | | Total Revenue | $106,849 | $102,069 | $82,696 | | Provision for credit losses | $46,061 | $10 | $20,185 | | Net Income | $29,785 | $60,460 | $21,840 | Earnings Per Share | Metric | 2022 | 2021 | 2020 | | :--- | :--- | :--- | :--- | | Basic EPS | $0.58 | $1.43 | $0.66 | | Diluted EPS | $0.57 | $1.42 | $0.66 | Notes to Consolidated Financial Statements The notes provide detailed information on accounting policies, including the CECL reserve, loan portfolio specifics, debt structure, related party transactions, and subsequent loan defaults - The total CECL Reserve as of December 31, 2022, was $71.3 million, comprising $66.0 million for funded loan commitments and $5.3 million for unfunded commitments, representing a significant increase from the prior year driven by macroeconomic factors[550][551][554] - As of December 31, 2022, the company had $227.5 million in unfunded loan commitments[605] - The company's financing agreements contain various financial covenants, including maintaining a maximum total debt to tangible net worth ratio of 4.50 to 1.00 and a minimum tangible net worth[573][575][579] Related Party Payments to Manager ($ in thousands) | Expense Type | 2022 ($ thousands) | 2021 ($ thousands) | 2020 ($ thousands) | | :--- | :--- | :--- | :--- | | Management fees | $11,456 | $9,384 | $7,323 | | Incentive fees | $3,442 | $2,752 | $836 | | G&A expenses | $3,777 | $3,016 | $3,653 | | Total | $18,840 | $15,161 | $11,912 | - Subsequent to year-end, in January and February 2023, three senior mortgage loans with a combined outstanding principal balance of $149.1 million entered into default; additionally, a defaulted loan with a principal of $14.3 million was sold for net proceeds of $9.8 million[668][669]