Ares Commercial Real Estate Corp - Quarter Report: 2014 June (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2014

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period           to

 

Commission File No. 001-35517

 

ARES COMMERCIAL REAL ESTATE CORPORATION

(Exact name of Registrant as specified in its charter)

 

 

One North Wacker Drive, 48th Floor, Chicago, IL 60606

(Address of principal executive office)  (Zip Code)

 

(312) 252-7500

(Registrant’s telephone number, including area code)

 

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:   Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class		Outstanding at August 4, 2014
Common stock, $0.01 par value		28,604,798

 

 

Table of Contents

 

ARES COMMERCIAL REAL ESTATE CORPORATION

 

INDEX

 

Part I.	Financial Information
Item 1.	Consolidated Financial Statements
	Consolidated Balance Sheets as of June 30, 2014 (unaudited) and December 31, 2013	2
	Consolidated Statements of Operations for the three and six months ended June 30, 2014 and June 30, 2013 (unaudited)	3
	Consolidated Statement of Stockholders’ Equity for the six months ended June 30, 2014 (unaudited)	4
	Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and June 30, 2013 (unaudited)	5
	Notes to Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	42
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	55
Item 4.	Controls and Procedures	57
Part II.	Other Information
Item 1.	Legal Proceedings	57
Item 1A.	Risk Factors	57
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	58
Item 3.	Defaults Upon Senior Securities	58
Item 4.	Mine Safety Disclosures	58
Item 5.	Other Information	58
Item 6.	Exhibits	59

 

 

 

Table of Contents

 

PART I — FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

 

			As of
			June 30, 2014					December 31, 2013
			(unaudited)
ASSETS
Cash and cash equivalents			$	20,152				$	20,100
Restricted cash			24,388					16,954
Loans held for investment ($428,282 and $493,783 related to consolidated VIE, respectively)			1,161,441					958,495
Loans held for sale, at fair value			55,928					89,233
Mortgage servicing rights, at fair value			58,558					59,640
Other assets ($2,167 and $2,552 of interest receivable related to consolidated VIE, respectively; $65,501 of certificates receivable related to consolidated VIE as of June 30, 2014)			101,121					32,493
Total assets			$	1,421,588				$	1,176,915
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Secured funding agreements			$	457,291				$	264,419
Warehouse lines of credit			48,199					-
Convertible notes			68,088					67,815
Commercial mortgage-backed securitization debt (consolidated VIE)			395,027					395,027
Allowance for loss sharing			14,440					16,480
Due to affiliate			2,974					2,796
Dividends payable			7,151					7,127
Other liabilities ($359 and $384 of interest payable related to consolidated VIE, respectively)			24,583					17,035
Total liabilities			1,017,753					770,699
Commitments and contingencies (Note 8)
STOCKHOLDERS’ EQUITY
Common stock, par value $0.01 per share, 450,000,000 shares authorized at June 30, 2014 and December 31, 2013, 28,604,798 and 28,506,977 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively			284					284
Additional paid-in capital			419,930					419,405
Accumulated deficit			(16,379)					(13,473)
Total stockholders’ equity			403,835					406,216
Total liabilities and stockholders’ equity			$	1,421,588				$	1,176,915

 

See accompanying notes to consolidated financial statements.

 

2

Table of Contents

 

ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

 

			For the three months ended June 30,										For the six months ended June 30,
			2014					2013					2014					2013
Net interest margin:			(unaudited)					(unaudited)					(unaudited)					(unaudited)
Interest income from loans held for investment			$	17,735				$	8,086				$	32,887				$	14,798
Interest expense			(6,835		)			(1,879		)			(11,907		)			(3,265		)
Net interest margin			10,900					6,207					20,980					11,533
Mortgage banking revenue:
Servicing fees, net			3,533					-					8,796					-
Gains from mortgage banking activities			5,446					-					6,832					-
Provision for loss sharing			1,180					-					1,061					-
Change in fair value of mortgage servicing rights			(1,888		)			-					(3,735		)			-
Mortgage banking revenue			8,271					-					12,954					-
Gain on sale of loans			-					-					680					-
Total revenue			19,171					6,207					34,614					11,533
Expenses:
Other interest expense			1,758					1,499					3,443					3,050
Management fees to affiliate			1,478					643					2,970					1,256
Professional fees			1,104					500					2,029					1,067
Compensation and benefits			4,510					-					8,531					-
Acquisition and investment pursuit costs			-					1,121					20					1,761
General and administrative expenses			2,600					453					4,819					936
General and administrative expenses reimbursed to affiliate			1,000					863					2,000					1,610
Total expenses			12,450					5,079					23,812					9,680
Changes in fair value of derivatives			-					2,137					-					1,739
Income from operations before income taxes			6,721					3,265					10,802					3,592
Income tax expense (benefit)			83					-					(591		)			-
Net income			$	6,638				$	3,265				$	11,393				$	3,592
Net income per common share:
Basic and diluted earnings per common share			$	0.23				$	0.32				$	0.40				$	0.37
Weighted average number of common shares outstanding:
Basic weighted average shares of common stock outstanding			28,453,739					10,215,782					28,448,181					9,720,477
Diluted weighted average shares of common stock outstanding			28,590,689					10,257,250					28,570,945					9,764,941
Dividends declared per share of common stock			$	0.25				$	0.25				$	0.50				$	0.50

 

See accompanying notes to consolidated financial statements.

 

3

 

Table of Contents

 

ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands, except share and per share data)

(unaudited)

 

							Additional						Total
		Common Stock					Paid-in			Accumulated			Stockholders’
		Shares		Amount			Capital			Deficit			Equity
Balance at December 31, 2013		28,506,977		$	284		$	419,405		$	(13,473)		$	406,216
Stock-based compensation		97,821		-			525			-			525
Net income		-		-			-			11,393			11,393
Dividends declared		-		-			-			(14,299)			(14,299)
Balance at June 30, 2014		28,604,798		$	284		$	419,930		$	(16,379)		$	403,835

 

See accompanying notes to consolidated financial statements.

 

4

Table of Contents

 

ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		For the Six Months Ended June 30,
		2014			2013
Operating activities:		(unaudited)			(unaudited)
Net income		$	11,393		$	3,592
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Amortization of deferred financing costs		3,288			453
Change in mortgage banking activities		(3,280)			-
Change in fair value of mortgage servicing rights		3,735			-
Accretion of deferred loan origination fees and costs		(1,593)			(1,268)
Provision for loss sharing		(1,061)			-
Cash paid to settle loss sharing obligations		(883)			-
Originations of mortgage loans held for sale		(151,426)			-
Sale of mortgage loans held for sale to third parties		103,040			-
Stock-based compensation		525			235
Changes in fair value of derivatives		-			(1,739)
Amortization of convertible notes issuance costs		443			372
Accretion of convertible notes		273			-
Depreciation expense		62			-
Deferred tax benefit		(129)			-
Changes in operating assets and liabilities:
Restricted cash		(1,135)			-
Other assets		(3,815)			(1,242)
Due to affiliate		178			243
Other liabilities		(1,937)			1,374
Net cash provided by (used in) operating activities		(42,322)			2,020
Investing activities:
Issuance of and fundings on loans held for investment		(267,719)			(186,402)
Principal repayment of loans held for investment		3,517			13,512
Proceeds from sale of a mortgage loan held for sale		80,197			-
Receipt of origination fees		2,141			1,664
Purchases of property and equipment		(244)			-
Payment of acquisition deposit		-			(1,000)
Net cash used in investing activities		(182,108)			(172,226)
Financing activities:
Proceeds from secured funding agreements		384,932			95,165
Repayments of secured funding agreements		(192,060)			(138,137)
Secured funding costs		(2,201)			(202)
Proceeds from issuance of common stock		-			243,000
Payment of offering costs		(113)			(8,141)
Proceeds from warehouse lines of credit		137,399			-
Repayments of warehouse lines of credit		(89,200)			-
Dividends paid		(14,275)			(4,634)
Net cash provided by financing activities		224,482			187,051
Change in cash and cash equivalents		52			16,845
Cash and cash equivalents, beginning of period		20,100			23,390
Cash and cash equivalents, end of period		$	20,152		$	40,235
Supplemental Information:
Interest paid during the period		$	10,814		$	5,188
Income taxes paid during the period		$	300		$	-
Supplemental disclosure of noncash investing and financing activities:
Dividends payable		$	7,151		$	6,822
Deferred financing and offering costs		$	-		$	715
Certificates receivable related to consolidated VIE		$	65,501		$	-

 

See accompanying notes to consolidated financial statements.

 

5

Table of Contents

 

ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of June 30, 2014

(unaudited)

 

1. ORGANIZATION

 

Ares Commercial Real Estate Corporation (together with its consolidated subsidiaries, the “Company” or “ACRE”) is 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). Through Ares Commercial Real Estate Management LLC (“ACREM” or the Company’s “Manager”), a Securities and Exchange Commission (“SEC”) registered investment adviser and a subsidiary of Ares Management L.P.  (“Ares Management”), a publicly traded, leading global alternative asset manager, it has investment professionals strategically located across the nation who directly source new loan opportunities for the Company with owners, operators and sponsors of commercial real estate (“CRE”) properties. The Company was formed and commenced operations in late 2011. The Company is a Maryland corporation and completed its initial public offering (the “IPO”) in May 2012. The Company is externally managed by its Manager, pursuant to the terms of a management agreement.

 

In the Company’s principal lending business, it is primarily focused on directly originating, managing and servicing a diversified portfolio of CRE debt-related investments for the Company’s own account. The Company’s target investments in its principal lending business include senior loans, bridge loans, subordinated mortgages and B-Notes, preferred equity and other CRE-related investments. These investments, which are referred to as the Company’s “principal lending target investments,” are generally held for investment and are secured, directly or indirectly, by office, multifamily, retail, industrial, lodging, senior living and other commercial real estate properties, or by ownership interests therein and include: (a) “transitional senior” mortgage loans, (b) “stretch senior” mortgage loans, (c) “bridge financing” mortgage loans, (d) subordinated real estate loans such as B-Notes, mezzanine loans, certain rated tranches of securitizations, and (e) other select CRE debt and preferred equity investments. “Transitional senior” mortgage loans provide strategic, flexible, short-term financing solutions for owners of transitional CRE middle-market assets that are the subject of a business plan that is expected to enhance the value of the property. “Stretch senior” mortgage loans provide flexible “one stop” financing for owners of CRE middle-market assets that are typically stabilized or near-stabilized properties with healthy balance sheets and steady cash flows. These mortgage loans typically have higher leverage (and thus higher loan-to-value ratios) than conventional mortgage loans provided by banks, insurance companies and other CRE lenders and are generally non-recourse to the borrower (as compared to conventional mortgage loans, which are often partial or full recourse to the borrower). Bridge loans provide short-term financing to borrowers ranging from six to 24 months in term and may be used to provide financing to borrowers seeking permanent loans from government and government-sponsored entities (collectively, “GSEs”) while they work through the application process or in the event the underlying properties need additional time to stabilize before locking in long-term debt.

 

The Company is also engaged in the mortgage banking business through its wholly owned subsidiary, ACRE Capital LLC (“ACRE Capital”), which the Company believes is complementary to its principal lending business. In this business segment, the Company primarily originates, sells and services multifamily and senior-living related loans under programs offered by GSEs, such as the Federal National Mortgage Association (“Fannie Mae”) and the Government National Mortgage Association (“Ginnie Mae”) and the Federal Housing Administration, a division of the U.S. Department of Housing and Urban Development (together with Ginnie Mae, “HUD”). ACRE Capital is approved as a Fannie Mae Delegated Underwriting and Servicing (“DUS”) lender, a Multifamily Accelerated Processing (“MAP”) and Section 232 LEAN lender for HUD, and a Ginnie Mae issuer. While the Company earns little interest from these activities as it generally only holds loans for short periods, the Company receives origination fees when it closes loans and sale premiums when it sells loans. The Company also retains the rights to service the loans, which are known as mortgage servicing rights (“MSRs”) and receives fees for such servicing during the life of the loans, which generally last ten years or more.

 

Since the Company operates both as a principal lender and a mortgage banker, the Company can offer a wider array of financing solutions to its 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. The Company also has the flexibility to provide a combination of solutions to its customers, including instances where the Company’s principal lending business provides a short-term, bridge loan to an owner of multifamily properties while the Company’s mortgage banking business seeks long-term permanent financing for the same customer. This provides the Company the opportunity to offer its customer an efficient “one stop” financial product and at the same time earn revenues at multiple times in the relationship with the customer. First, the Company earns interest and interest-related income while holding the short term bridge loan.

 

6

Table of Contents

 

Second, the Company earns origination fees and sale premiums when the Company provides permanent financing and sells the loans under GSE programs. Third, the Company earns servicing fees from MSRs that the Company retains on the permanent loans.

 

The Company has elected and qualified to be taxed as a real estate investment trust (“REIT”) for U.S. federal income tax purposes under the Internal Revenue Code of 1986, as amended, commencing with its taxable year ended December 31, 2012. The Company generally will not be subject to U.S. federal income taxes on its REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains, to the extent that it annually distributes all of its REIT taxable income to stockholders and complies with various other requirements as a REIT.

 

In connection with the acquisition of ACRE Capital, the Company created a wholly owned subsidiary, ACRE Capital Holdings LLC (“TRS Holdings”), to hold the common units of ACRE Capital. The Company formed a wholly owned subsidiary in December 2013, ACRC Lender W TRS LLC (“ACRC W TRS”) and in March 2014, ACRC Lender U TRS LLC (“ACRC U TRS”) in order to issue and hold certain loans intended for sale. Entity classification elections to be taxed as a corporation and taxable REIT subsidiary (“TRS”) elections were made with respect to TRS Holdings, ACRC W TRS and ACRC U TRS. A TRS is an entity taxed as a corporation other than a REIT in which a REIT directly or indirectly holds equity, and that has made a joint election with such REIT to be treated as a TRS. Other than some activities relating to lodging and health care facilities, a TRS generally may engage in any business, including investing in assets and engaging in activities that could not be held or conducted directly by the Company without jeopardizing its qualification as a REIT. A TRS is subject to applicable U.S. federal, state, local and foreign income tax on its taxable income. In addition, as a REIT, the Company also may be subject to a 100% excise tax on certain transactions between it and its TRS that are not conducted on an arm’s-length basis.

 

2. SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with generally accepted accounting principles (“GAAP”) and include the accounts of the Company, the consolidated variable interest entity (“VIE”) for which the Company controls and is the primary beneficiary, and its wholly owned subsidiaries. The consolidated financial statements reflect all adjustments and reclassifications that, in the opinion of management, are necessary for the fair presentation of the Company’s results of operations and financial condition as of and for the periods presented. All intercompany balances and transactions have been eliminated.

 

Interim financial statements are prepared in accordance with United States GAAP for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. The current period’s results of operations will not necessarily be indicative of results that ultimately may be achieved for the year ending December 31, 2014.

 

Variable Interest Entities

 

The Company evaluates all of its interests in VIEs for consolidation. When the Company’s interests are determined to be variable interests, the Company assesses whether it is deemed to be the primary beneficiary of the VIE. The primary beneficiary of a VIE is required to consolidate the VIE. Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, Consolidation (“ASC 810”), defines the primary beneficiary as the party that has both (i) the power to direct the activities of the VIE that most significantly impact its economic performance, and (ii) the obligation to absorb losses and the right to receive benefits from the VIE which could be potentially significant. The Company considers its variable interests, as well as any variable interests of its related parties in making this determination. Where both of these factors are present, the Company is deemed to be the primary beneficiary and it consolidates the VIE. Where either one of these factors is not present, the Company is not the primary beneficiary and it does not consolidate the VIE.

 

To assess whether the Company has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, the Company considers all facts and circumstances, including its role in establishing the VIE and its ongoing rights and responsibilities. This assessment includes first, identifying the activities that most significantly impact the VIE’s economic performance; and second, identifying which party, if any, has power over those activities. In general, the parties that make the most significant decisions affecting the VIE or have the right to unilaterally remove those decision makers are deemed to have the power to direct the activities of a VIE.

 

7

Table of Contents

 

To assess whether the Company has the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE, the Company considers all of its economic interests, including debt and equity investments, servicing fees, and other arrangements deemed to be variable interests in the VIE. This assessment requires that the Company applies judgment in determining whether these interests, in the aggregate, are considered potentially significant to the VIE. Factors considered in assessing significance include: the design of the VIE, including its capitalization structure; subordination of interests; payment priority; relative share of interests held across various classes within the VIE’s capital structure; and the reasons why the interests are held by the Company.

 

For VIEs in which the Company is determined to be the primary beneficiary, all of the underlying assets, liabilities, equity, revenue and expenses of the structures are consolidated into the Company’s consolidated financial statements.

 

The Company performs an ongoing reassessment of: (1) whether any entities previously evaluated under the majority voting interest framework have become VIEs, based on certain events, and therefore are subject to the VIE consolidation framework, and (2) whether changes in the facts and circumstances regarding its involvement with a VIE causes the Company’s consolidation conclusion regarding the VIE to change.

 

See Note 16 for further discussion of the Company’s VIEs.

 

Segment Reporting

 

The Company has two reportable business segments: principal lending and mortgage banking. See Note 18 for further discussion of the Company’s reportable business segments.

 

Reclassifications

 

Certain prior period amounts have been reclassified to conform to the current period presentation. Deferred financing costs and accrued interest receivable have been reclassified into other assets in the consolidated balance sheets. Derivative liability and accounts payable and accrued expenses have been reclassified into other liabilities in the consolidated balance sheets. Interest receivable has been reclassified into other assets in the consolidated statements of cash flows. Accounts payable, refundable deposits and accrued expenses have been reclassified into other liabilities in the consolidated statements of cash flows. The unrealized loss on the $69.0 million aggregate principal amount of unsecured 7.00% Convertible Senior Notes due 2015 (the “2015 Convertible Notes”) has been reclassified into changes in fair value of derivatives in the consolidated statements of operations.

 

Cash and Cash Equivalents

 

Cash and cash equivalents include funds on deposit with financial institutions, including demand deposits with financial institutions. Cash and short-term investments with an original maturity of three months or less when acquired are considered cash and cash equivalents for the purpose of the consolidated balance sheets and statements of cash flows.

 

Restricted Cash

 

Restricted cash includes escrow deposits for taxes, insurance, leasing outlays, capital expenditures, tenant security deposits and payments required under certain loan agreements. These escrow deposits are held on behalf of the respective borrowers and are offset by escrow liabilities included in other liabilities in the consolidated balance sheets. As of June 30, 2014 and December 31, 2013, through ACRE Capital, the Company held restricted cash, which consisted of reserves that are a requirement of the Fannie Mae DUS program and borrower deposits, which represent funds that were collected for the processing of the borrowers loan applications and loan commitments.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash, loans held for investment, MSRs, loans held for sale, interest receivable and derivative financial instruments. The Company places its cash and cash equivalents with financial institutions and, at times, cash held may exceed the FDIC-insured limit. The Company has exposure to credit risk on its loans held for investment and through its subsidiary ACRE Capital, the Company has exposure on credit risk on loans held for sale and the servicing portfolio whereby ACRE Capital shares in

 

8

Table of Contents

 

the risk of loss (see Note 7). The Company and the Company’s Manager seek to manage credit risk by performing due diligence prior to origination or acquisition and through the use of non-recourse financing, when and where available and appropriate.

 

Loans Held for Investment

 

The Company originates CRE debt and related instruments generally to be held for investment. Loans that are held for investment are carried at cost, net of unamortized loan fees and origination costs, unless the loans are deemed impaired. Impairment occurs when it is deemed probable that the Company 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, the Company 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.

 

Each loan classified as held for investment is evaluated for impairment on a periodic basis. Loans are collateralized by real estate. The extent of any credit deterioration associated with the performance and/or value of the underlying collateral property and the financial and operating capability of the borrower could impact the expected amounts received. The Company monitors performance of its 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.

 

In addition, the Company evaluates the entire portfolio to determine whether the portfolio has any impairment that requires a valuation allowance on the remainder of the loan portfolio. As of June 30, 2014 and December 31, 2013, with respect to the Company’s loans held for investment, no impairment charges have been recognized.

 

Preferred equity investments, where the risks and payment characteristics are equivalent to mezzanine loans, are accounted  for as loans held for investment and are carried at cost, net of unamortized loan fees and origination costs, unless the loans are deemed impaired,  and  are  included  in loans held for investment in the Company’s consolidated balance sheets.  The Company accretes or amortizes any discounts or premiums over the life of the related loan receivable utilizing the effective interest method.

 

Loans Held for Sale

 

Through its subsidiaries, including ACRE Capital, ACRC U TRS and ACRC W TRS, the Company originates mortgage loans held for sale, which are recorded at fair value. The holding period for loans originated by ACRE Capital is approximately 30 days. The carrying value of the mortgage loans sold is reduced by the value allocated to the associated retained MSRs based on relative fair value at the time of the sale. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the adjusted value of the related mortgage loans sold.

 

Although the Company generally holds its target investments as long-term investments within its principal lending business, the Company may occasionally classify some of its investments as held for sale. Investments held for sale will be carried at fair value within loans held for sale, at fair value in the Company’s consolidated balance sheets, with changes in fair value recorded through earnings. The fees received are deferred and recognized as part of the gain or loss on sale. As of June 30, 2014, the Company did not have any loans held for sale in its principal lending business. As of December 31, 2013, the Company had one loan held for sale in its principal lending business of $84.8 million, net of deferred fees, included in the $89.2 million of loans held for sale in the consolidated balance sheets.

 

Mortgage Servicing Rights

 

When a mortgage loan is sold, ACRE Capital retains the right to service the loan and recognizes the MSR at fair value. The initial fair value represents expected net cash flows from servicing, as well as interest earnings on escrows and interim cash balances, borrower prepayment penalties, delinquency rates, late charges along with ancillary fees that are discounted at a rate that reflects the credit and liquidity risk of the MSR over the estimated life of the underlying loan. After initial recognition, changes in the MSR fair

 

9

Table of Contents

 

value are included within change in fair value of mortgage servicing rights in the Company’s consolidated statements of operations for the period in which the change occurs.

 

Intangible Assets

 

Intangible assets consist of ACRE Capital’s licenses permitting it to participate in programs offered by Fannie Mae, Ginnie Mae and HUD. These licenses are intangible assets with indefinite lives. The Company evaluates identified intangibles for impairment annually or if other events or circumstances indicate that the carrying value may be impaired.

 

Debt Issuance Costs

 

Debt issuance costs are capitalized and amortized over the terms of the respective debt instrument. Debt issuance costs related to debt securitizations are capitalized and amortized over the term of the underlying loans using the effective interest method. When an underlying loan is prepaid in a debt securitization, the related unamortized debt issuance costs are charged to expense based on a pro-rata share of the debt issuance costs being allocated to the specific loans that were prepaid. Amortization of debt issuance costs is included in interest expense in the Company’s consolidated statements of operations while the unamortized balance is included in other assets in the Company’s consolidated balance sheets.

 

Derivative Financial Instruments

 

The Company does not hold or issue derivative instruments for trading purposes. The Company recognizes derivatives on its consolidated balance sheets, measures them at their estimated fair value and recognizes changes in their estimated fair value in the Company’s consolidated statements of operations for the period in which the change occurs.

 

Through its subsidiary, ACRE Capital, the Company enters into loan commitments with borrowers on loan originations whereby the interest rate on the prospective loan is determined prior to funding. In general, ACRE Capital simultaneously enters into forward sale commitments with investors in order to hedge interest rate exposure on loan commitments. The forward sale commitment with the investor locks in an interest rate and price for the sale of the loan. The terms of the loan commitment with the borrower and the forward sale commitment with the investor are matched with the objective of hedging interest rate risk. Loan commitments and forward sale commitments are considered undesignated derivative instruments. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value, with changes in fair value recorded in earnings.

 

On December 19, 2012, the Company issued the 2015 Convertible Notes. The conversion features of the 2015 Convertible Notes were deemed to be an embedded derivative under FASB ASC Topic 815, Derivatives and Hedging (“ASC 815”). In accordance with ASC 815, the Company was required to bifurcate the embedded derivative related to the conversion features of the 2015 Convertible Notes. Prior to June 26, 2013, the Company recognized the embedded derivative as a liability on its balance sheet, measured at its estimated fair value and recognized changes in its estimated fair value within changes in fair value of derivatives in the Company’s consolidated statements of operations for the period in which the change occurs. See Note 6 for information on the derivative liability reclassification.

 

Fair Value Measurements

 

GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The financial instruments recorded at fair value on a recurring basis in the Company’s consolidated financial statements are derivative financial instruments, MSRs and loans held for sale. The Company has not elected the fair value option for certain other financial instruments, including loans held for investment, secured funding agreements and other debt instruments. Such financial instruments are carried at cost. Fair value is separately disclosed (see Note 13).

 

Allowance for Loss Sharing

 

When a loan is sold under the Fannie Mae DUS program, ACRE Capital undertakes an obligation to partially guarantee the performance of the loan. The date ACRE Capital commits to make a loan to a borrower, a liability for the fair value of the obligation undertaken in issuing the guaranty is recognized. Subsequent to the initial commitment date, the Company monitors the performance of each loan for events or circumstances which may signal a liability to be recognized if there is a probable and estimable loss. The initial fair value of the guarantee is estimated by examining historical loss share experienced in the ACRE Capital Fannie Mae DUS portfolio since

 

10

Table of Contents

 

inception. The initial fair value of the guarantee is included within provision for loss sharing in the Company’s consolidated statements of operations. These historical loss shares serve as a basis to derive a loss share rate which is then applied to the current ACRE Capital DUS portfolio (net of specifically identified impaired loans that are subject to a separate loss share reserve analysis).

 

Servicing Fee Payable

 

ACRE Capital provides additional payments to certain personnel by providing them with a percentage of the servicing fee revenue that is earned by ACRE Capital, which is initially recorded as a liability when the MSR is obtained and expensed as the servicing fee is earned over the life of the related mortgage loan. ACRE Capital incurs an expense over the life of each loan as long as the related loan is performing. If a particular loan is not performing, the recipient will not receive the additional compensation on that loan, and if a loss sharing event is triggered, the recipient will not receive a portion of the additional compensation on other loans. The servicing fee payable is included within other liabilities in the consolidated balance sheets and the related expense is included within servicing fee revenue on a net basis in the consolidated statements of operations.

 

Revenue Recognition

 

Interest income from loans held for investment is accrued based on the outstanding principal amount and the contractual terms of each loan. For loans held for investment, origination fees, contractual exit fees and direct loan origination costs are also recognized in interest income from loans held for investment over the initial loan term as a yield adjustment using the effective interest method. Fees earned on loans held for sale are included within gains from mortgage banking activities below.

 

Servicing fees are earned for servicing mortgage loans, including all activities related to servicing the loans, and are recognized as services are provided over the life of the related mortgage loan. Also included in servicing fees are the net fees earned on borrower prepayment penalties and interest earned on borrowers’ escrow payments and interim cash balances, along with other ancillary fees and reduced by write-offs of MSRs for loans that are prepaid.

 

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 attributable to the loan commitments and forward sale commitments. The initial fair value of MSRs, loan origination fees, gain on the sale of loans, and certain direct loan origination costs for loans held for sale are recognized when ACRE Capital commits to make a loan to a borrower. When the Company settles a sale agreement and transfers the mortgage loan to the buyer, the Company recognizes a MSR asset equal to the present value of the expected net cash flows associated with the servicing of loans sold.

 

Stock-Based Compensation

 

The Company recognizes the cost of stock-based compensation, which is included within compensation and benefits for ACRE Capital and general and administrative expenses for ACRE in the consolidated statements of operations. The fair value of the time vested restricted stock or restricted stock units granted is recorded to expense on a straight-line basis over the vesting period for the award, with an offsetting increase in stockholders’ equity. For grants to directors, officers and employees, the fair value is determined based upon the market price of the stock on the grant date.

 

Certain ACRE Capital employees were granted restricted stock units that vest in proportion to certain financial performance targets being met over a specified period of time. The fair value of the performance based restricted stock or restricted stock units granted is recorded to expense on an accelerated basis, using the accelerated attribution method, over the performance period for the award, with an offsetting increase in stockholders’ equity. For performance based measures, compensation expense, net of estimated forfeitures, is recorded based on the Company’s estimate of the probable achievement of such measures.

 

Underwriting Commissions and Offering Costs

 

Underwriting commissions and offering costs incurred in connection with common stock or debt offerings are reflected as a reduction of additional paid-in capital. Costs incurred that are not directly associated with the completion of a common stock or debt offering are expensed when incurred. Underwriting commissions that are the responsibility of and paid by a related party, such as the Company’s Manager, are reflected as a contribution of additional paid-in capital from a sponsor in the consolidated financial statements.

 

11

Table of Contents

 

Income Taxes

 

The Company has elected and qualified for taxation as a REIT commencing with its taxable year ended December 31, 2012. As a result of the Company’s REIT qualification and its distribution policy, the Company does not generally pay U.S. federal corporate level income taxes. Many of the REIT requirements, however, are highly technical and complex. To continue to qualify as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that the Company distribute annually at least 90% of the Company’s REIT taxable income to the Company’s stockholders. If the Company fails to continue to qualify as a REIT in any taxable year and does not qualify for certain statutory relief provisions, the Company will be subject to U.S. federal and state income taxes at regular corporate rates (including any applicable alternative minimum tax) beginning with the year in which it fails to qualify and may be precluded from being able to elect to be treated as a REIT for the Company’s four subsequent taxable years. Even though the Company currently qualifies for taxation as a REIT, the Company may be subject to certain U.S. federal, state, local and foreign taxes on the Company’s income and property and to U.S. federal income and excise taxes on the Company’s undistributed REIT taxable income.

 

The Company currently owns 100% of the equity of TRS Holdings, ACRC U TRS and ACRC W TRS, each of which is a TRS. A TRS is subject to applicable U.S. federal, state, local and foreign income tax on its taxable income. In addition, as a REIT, the Company also may be subject to a 100% excise tax on certain transactions between it and its TRS that are not conducted on an arm’s-length basis. For financial reporting purposes, a provision for current and deferred taxes has been established for the portion of the Company’s GAAP consolidated earnings recognized by TRS Holdings, ACRC U TRS and ACRC W TRS.

 

FASB ASC Topic 740, Income Taxes (“ASC 740”), prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company has analyzed its various federal and state filing positions and believes that its income tax filing positions and deductions are well documented and supported. As of June 30, 2014 and December 31, 2013, based on the Company’s evaluation, there is no reserve for any uncertain income tax positions. TRS Holdings, ACRC U TRS and ACRC W TRS recognize interest and penalties related to unrecognized tax benefits within income tax expense in the consolidated statements of operations. Accrued interest and penalties are included within other liabilities in the consolidated balance sheets.

 

Comprehensive Income

 

For the three and six months ended June 30, 2014 and 2013, comprehensive income equaled net income; therefore, a separate consolidated statement of comprehensive income is not included in the accompanying consolidated financial statements.

 

Earnings per Share

 

The Company calculates basic earnings (loss) per share by dividing net income (loss) allocable to common stockholders for the period by the weighted-average shares of common stock outstanding for that period after consideration of the earnings (loss) allocated to the Company’s restricted stock, which are participating securities as defined in GAAP. Diluted earnings (loss) per share takes into effect any dilutive instruments, such as restricted stock and convertible debt, except when doing so would be anti-dilutive. With respect to the 2015 Convertible Notes, the Company has the ability and intention to settle the principal in cash and to settle any amount above par in shares of the Company’s common stock if the conversion options were exercised. As such, the Company is applying the treasury stock method when determining the dilutive impact on earnings per share.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Actual results could differ from those estimates.

 

Business Combinations

 

The Company accounts for business combinations using the acquisition method of accounting, under which the purchase price of the acquisition is allocated to the assets acquired and liabilities assumed using the fair values determined by management as of the acquisition date. The Company recognizes identifiable assets acquired and liabilities (both specific and contingent) assumed at their fair values at the acquisition date. Furthermore, acquisition-related costs, such as due diligence, legal and accounting fees, are not capitalized or applied in determining the fair value of the acquired assets. The excess of the assets acquired and liabilities assumed

 

12

Table of Contents

 

over the purchase price is recognized as a gain on acquisition. During the measurement period, the Company records adjustments to the assets acquired and liabilities assumed with corresponding adjustments to the gain on acquisition. After the measurement period, which could be up to one year after the transaction date, subsequent adjustments are recorded through earnings.

 

Costs Associated with Restructuring Activities

 

The Company began restructuring and relocating certain ACRE Capital support services during the three months ended March 31, 2014.  The Company will incur costs related to these restructuring activities, including employee termination costs and office relocation costs.  The employee termination costs are associated with the severance of certain employees, retention bonuses and guaranteed bonuses to certain key employees, insurance and outplacement, which will be accounted for on a straight-line basis over the period from notification through each employee’s termination date.  If employees are required to render service (beyond a minimum retention period) in order to receive the termination benefits, a liability for employee termination costs is measured initially at the communication date based on its fair value, as of the termination date, and recognized ratably over the future service period. Office relocation costs include costs that will be incurred in the physical move of offices and incremental rent costs, which will be expensed when space is vacated. The costs incurred to date are included within general and administrative expenses in the Company’s consolidated statements of operations.

 

New Accounting Pronouncements

 

In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. The guidance in this update supersedes the revenue recognition requirements in Topic 605, “Revenue Recognition.” Under the new guidance, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendments in ASU No. 2014-09 are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact of adopting this ASU on its consolidated financial statements.

 

 

3.                                      LOANS HELD FOR INVESTMENT

 

As of June 30, 2014, the Company had originated or co-originated 40 loans secured by CRE middle market properties, excluding six loans that were repaid since inception. The aggregate originated commitment under these loans at closing was approximately $1.3 billion and outstanding principal was $1.2 billion as of June 30, 2014. During the six months ended June 30, 2014, the Company funded approximately $273.1 million and received repayments of $69.0 million as described in more detail in the tables below. Such investments are referred to herein as the Company’s investment portfolio. As of June 30, 2014, 74.9% of the Company’s loans have LIBOR floors, with a weighted average floor of 0.38%, calculated based on loans with LIBOR floors. References to LIBOR or “L” are to 30-day LIBOR (unless otherwise specifically stated).

 

The Company’s investments in mortgages and loans held for investment are accounted for at amortized cost. The following tables summarize the Company’s loans held for investment as of June 30, 2014 and December 31, 2013:

 

		June 30, 2014
$ in thousands		Carrying Amount (1)			Outstanding Principal (1)			Weighted Average Interest Rate		Weighted Average Unleveraged Effective Yield (2)		Weighted Average Remaining Life (Years)
Senior mortgage loans		$	1,036,799		$	1,043,673		4.8%		5.4%		2.2
Subordinated debt and preferred equity investments		124,642			125,857			9.6%		10.0%		3.8
Total		$	1,161,441		$	1,169,530		5.4%		5.9%		2.4

 

		December 31, 2013
$ in thousands		Carrying Amount (1)			Outstanding Principal (1)			Weighted Average Interest Rate		Weighted Average Unleveraged Effective Yield (2)		Weighted Average Remaining Life (Years)
Senior mortgage loans		$	867,578		$	873,781		5.1%		5.6%		2.4
Subordinated debt and preferred equity investments		90,917			91,655			9.8%		10.2%		3.6
Total		$	958,495		$	965,436		5.5%		6.0%		2.5

 

(1)                                 The difference between the Carrying Amount and the Outstanding Principal face amount of the loans held for investment consists of unamortized purchase discount, deferred loan fees and loan origination costs.

 

13

Table of Contents

 

(2)                                 Unleveraged Effective Yield is the compounded effective rate of return that would be earned over the life of the investment based on the contractual interest rate (adjusted for any deferred loan fees, costs, premium or discount) and assumes no dispositions, early prepayments or defaults. The Total Weighted Average Unleveraged Effective Yield is calculated based on the average of Unleveraged Effective Yield of all loans held by the Company as of June 30, 2014 and December 31, 2013 as weighted by the Outstanding Principal balance of each loan.

 

14

 

 

Table of Contents

 

A more detailed listing of the Company’s current investment portfolio, based on information available as of June 30, 2014 is as follows:

 

(amounts in millions, except percentages)

 

Loan Type		Location		Outstanding Principal (1)			Carrying Amount (1)			Interest Rate				Unleveraged Effective Yield (2)		Maturity Date (3)		Payment Terms (4)
Transitional Senior Mortgage Loans:
Office		CA		$	75.0		$	74.4		L+3.75%				4.2%		Aug 2017		I/O
Retail		IL		70.0			69.4			L+4.25%				4.9%		Aug 2017		I/O
Office		TX		55.8			54.8			L+5.00%				6.1%		Jan 2017		I/O
Apartment		FL		49.1			48.9			L+4.80%				5.9%		Jan 2016		I/O
Apartment		GA		45.1			45.1			L+4.95%		(5)		5.7%		Apr 2016		I/O
Apartment		TX		42.6			42.4			L+3.75%				4.5%		July 2016		I/O
Industrial		MO and KS		38.0			37.7			L+4.30%				5.1%		Jan 2017		I/O
Apartment		GA		37.8			37.8			L+4.95%		(5)		5.7%		Apr 2016		I/O
Apartment		NY		37.7			37.4			L+5.00%				6.1%		Oct 2017		I/O
Apartment		TX		34.9			34.7			L+4.70%				5.6%		Apr 2016		I/O
Apartment		FL		34.3			34.0			L+3.75%				4.7%		Mar 2017		I/O
Apartment		TX		33.8			33.6			L+3.75%				4.5%		July 2016		I/O
Office		TX		33.5			33.4			L+5.75%-L+5.25%		(6)		7.6%		Mar 2015		I/O
Office		FL		31.3			31.3			L+5.25%		(7)		6.3%		Feb 2015		I/O
Office		OH		29.6			29.5			L+5.35%-L+5.00%		(8)		6.0%		Nov 2015		I/O
Office		CA		27.5			27.2			L+4.50%				5.2%		Apr 2017		I/O
Apartment		TX		26.3			26.1			L+3.65%				4.3%		Jan 2017		I/O
Office		KS		25.5			25.3			L+5.00%				5.8%		Mar 2016		I/O
Apartment		TX		24.0			23.8			L+3.65%				4.3%		Jan 2017		I/O
Apartment		GA		23.1			23.1			L+4.95%		(5)		5.7%		Apr 2016		I/O
Apartment		AZ		21.8			21.7			L+4.25%				5.9%		Sep 2015		I/O
Apartment		GA		20.8			20.6			L+3.85%				4.8%		May 2017		I/O
Industrial		CA		19.6			19.4			L+5.25%				6.0%		May 2017		I/O
Industrial		VA		19.0			18.9			L+5.25%				6.4%		Dec 2015		I/O
Office		CA		15.1			15.0			L+3.75%				4.5%		July 2016		I/O
Apartment		NY		15.0			14.8			L+4.50%				5.2%		Dec 2016		I/O
Office		CA		14.8			14.7			L+4.50%				5.3%		July 2016		I/O
Apartment		NC		14.3			14.1			L+4.00%				4.8%		Apr 2017		I/O
Apartment		FL		12.8			12.7			L+3.80%				4.6%		Feb 2017		I/O
Office		CO		10.8			10.8			L+5.50%				7.4%		Jan 2015		I/O
Apartment		FL		10.2			10.1			L+3.80%				4.6%		Feb 2017		I/O
Stretch Senior Mortgage Loans:
Office		FL		47.3			47.3			L+5.25%		(9)		5.4%		Apr 2016		I/O
Industrial		OH		32.7			32.4			L+4.20%				4.7%		May 2018		I/O
Office		CA		14.5			14.4			L+4.75%				5.7%		Feb 2016		I/O
Subordinated Debt and Preferred Equity Investments:
Office		IL		37.0			36.7			8.75%				9.1%		Aug 2016		I/O
Apartment		NY		33.3			33.1			L+7.46%		(10)		7.9%		Jan 2019		I/O
Apartment		GA and FL		22.6			22.0			L+11.85%		(11)		12.4%		June 2021		I/O
Office		GA		14.3			14.3			10.50%		(12)		11.0%		Aug 2017		I/O
Apartment		NY		13.8			13.7			11.50%		(13)		11.9%		Nov 2016		I/O
Apartment		TX		4.9			4.8			L+11.00%		(14)		11.5%		Oct 2016		I/O
Total/Average				$	1,169.5		$	1,161.4						5.9%

 

 

(1)	The difference between the Carrying Amount and the Outstanding Principal face amount of the loans held for investment consists of unamortized purchase discount, deferred loan fees and loan origination costs.

 

15