Co-authored by Treading Softly.
I know not everyone likes to get out and hunt, fish, hike, or camp. However, even if you haven’t experienced it, I’m sure you can imagine using a net to capture a large amount of of fish. You realize that sometimes, in order to pull that net into your boat, you will have to grab a rope and pull it towards you with one hand and then with the other: surrender the fist. This technique will help you get the net in quickly, producing the largest number of fish that cannot 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 market. I believe that being an active market participant is the best way to unlock long-term and lasting wealth for the average person. I also recognize that sometimes, the biggest opportunities in the market to earn massive amounts of income for decades to come come from sectors that others are rapidly exiting, either out of fear or misunderstanding.
Today I want to look at an opportunity that I bought hand over hand. I have cast my net in this sector and am attracting high quality picks that are generating double digit returns that are completely covered because others are fleeing the sector in fear.
Let’s dive in!
AKRE: Making lemonade
Ares Commercial Real Estate Corporation (NYSE:ACRE), giving over 13%, reported Third quarter earnings similar to what we’ve seen with other commercial mortgage real estate investment trusts, or mREITs. Cash flow remains healthy with diluted earnings of $0.25, including a $0.09 non-cash write-down, implying a recurring DE of $0.34/share. ACRE it is achieving this level of earnings while operating at a below-average leverage level of just 2.0x. spring.
On the other hand, it seems clear that there is some pressure on borrowers, causing some of their loans to default. During the quarter, AKRE resolved two problem loans.
The first was a mixed-use property in Florida that the borrower voluntarily signed over the property’s deed. The property is a mix of office and retail, which is cash flow positive, and in the earnings call, management stated that the cash flow they were getting from the property is “similar” to the cash flow they were borrowing. ACRE is holding it and operating the property on an unassessed basis. Management discussed the option of using the property as collateral for a loan as an option to increase liquidity or potentially sell at a higher price in the future when real estate conditions improve.
The other failed property resolved during the quarter was a short sale of a hotel property in Illinois. ACRE realized a loss of $4.9 million, determining that it was better to withdraw their capital to invest elsewhere than invest the capital needed to optimize the property for sale. This property has not paid interest since January 2023, so while the realized loss is reflected in the income statement, the cash flow impact has already been realized in the second quarter.
One thing that sets mortgage REITs apart from banks is that they have a variety of options for dealing with defaulted mortgages. Sometimes, they can take over the property and run it themselves; other times, they will choose to sell it, recognize the loss and invest in another property.
Management telegraphed that they expect to settle several other properties in the fourth quarter, including $70 million worth of office space. When we look at the 10-Q, we can see that ACRE has made positive progress towards managing loans that are in their lowest risk ratings. In the third quarter, they had $380.4 million in loans at risk rating 4 and $82.5 million in loans at risk rating 5 for a total of about $463 million in loans at risk. spring.
That’s down from the $574 million in bad loans reported in the second quarter. spring.
In the fourth quarter, management expects to settle approximately $70 million of these loans. This will go a long way towards providing a more stable outlook for the future. Until these loans are resolved, there won’t be a concrete number on what the impact on book value will be. Currently, ACRE is reporting a book value of $12.62 after CECL (Current Expected Credit Loss) provisions. Before reserves, the book value is $14.75. Realized losses may be higher or lower than the amount currently reserved for CECL. As their hard loans are resolved, we should have a clearer picture.
The current market price, near $10/share, is estimating far more extreme credit losses than ACRE has calculated with CECL. Much more? With 54.8 million shares outstanding, ACRE’s trading at $2.62 below book value creates room for $143.5 million in credit losses. This is more than double CECL’s current reserve.
This would be a much larger loss rate than ACRE has historically experienced. T4 should help bring more clarity, further reducing bad loans, so we don’t have to speculate on what the losses might be; we will know them.
Meanwhile, management is becoming more bullish on new loan opportunities, noting that new loans are being made at lower loan values and higher spreads than existing loans. Last quarter, ACRE invested $69 million in loans for multifamily and self-storage properties.
Since ACRE has been operating at a lower level of leverage, it has plenty of room to grow when management sees an opportunity that will increase cash flow and help rebuild book value from any losses it realizes. We expect ACRE to remain fairly conservative in Q4 and Q1 2024 and will look to expand more aggressively and consider increasing leverage once current properties at risk levels 4 and 5 are resolved.
ACRE is currently trading at a 20%+ discount to book value, which already reflects CECL. We are happy to buy the discount and collect our dividend as we await the next expansion cycle – which could begin next spring.
The commercial real estate sector is one that many are fleeing in a panic. I totally understand why so many are doing this. Commercial real estate loans that are taken out by financial institutions such as banks or credit unions are more likely to simply be foreclosed and the property sold, fire sale, at auction for the bank to recoup some of its investment. ACRE is not one of those institutions. It originates a completely different type of credit related to the same sector; because of this, they have been able to not only see great returns in a sector where others are failing, but are also more agile and able to adapt to the prevailing market winds. There is a famous quote by Douglas Adams that says, “Ships hung in the sky in the same way as bricks.“In the commercial real estate sector, ACRE is challenging expectations through exceptional management.
When it comes to retirement, the last thing you want to worry about is keeping up with the crowd. One of the biggest financial mistakes so many make is trying to keep up with the perceived wealth of others around them – it’s the concept of “keeping up with the Joneses”. Your retirement will be completely unique to you. Your financial needs and expectations, while they may be similar to others, will be unique when adjusted to what you want to do with retirement and your personal desires and experiences. Often, the answer, however, can be similar – you’ll need income to pay for all of this, whether you need a lot of income to pay a large pension or a little income to pay a smaller one. modest I don’t want you to have to pinch pennies and sit in retirement because of your financial planning. I want you to have financial success and financial security. This is something that My Income Method can provide.
This is the beauty of my income method. That’s the beauty of income investing.