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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________________________________________________________
FORM 10-Q
☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2021
OR
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission File No. 001-35517
ARES COMMERCIAL REAL ESTATE CORPORATION
(Exact name of Registrant as specified in its charter)
| | | | | | | | |
Maryland | | 45-3148087 |
(State or other jurisdiction of | | (I.R.S. Employer |
incorporation or organization) | | Identification Number) |
245 Park Avenue, 42nd Floor, New York, NY 10167
(Address of principal executive offices) (Zip Code)
(212) 750-7300
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act: | | | | | | | | |
Title of each class | Trading Symbol(s) | Name of each exchange on which registered |
Common stock, $0.01 par value per share | ACRE | New York Stock Exchange |
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 ý No o
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ý No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
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Large accelerated filer | ☐ | | Accelerated filer | ☒ |
Non-accelerated filer | ☐ | | Smaller reporting company | ☐ |
Emerging growth company | ☐ | | | |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
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 November 2, 2021 |
Common stock, $0.01 par value | | 47,001,821 |
TABLE OF CONTENTS
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Part I. Financial Information | | |
Item 1. Consolidated Financial Statements | | |
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FORWARD-LOOKING STATEMENTS
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 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, 2020. 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 (“ACRE” and, together with its consolidated subsidiaries, the “Company,” “we,” “us” and “our”). The forward-looking statements contained in this report involve a number of risks and uncertainties, including statements concerning:
•our business and investment strategy;
•our projected operating results;
•the return or impact of current and future investments;
•the severity and duration of the novel coronavirus (“COVID-19”) pandemic;
•the impact of the COVID-19 pandemic, on our business and the United States and global economies;
•the impact of the COVID-19 pandemic on the real estate industry and our borrowers, the performance of the properties securing our loans that may cause deterioration in the performance of our investments and, potentially, principal losses to us;
•whether, or how much, we or our borrowers have benefited or may benefit from government stimulus programs in response to the COVID-19 pandemic;
•the length of the economic slowdown resulting from the COVID-19 pandemic as well as the rate and extent of economic recovery;
•management’s current estimate of expected credit losses and current expected credit loss reserve;
•the collectability and timing of cash flows, if any, from our investments;
•estimates relating to our ability to make distributions to our stockholders in the future;
•defaults by borrowers in paying amounts due on outstanding indebtedness and our ability to collect all amounts due according to the contractual terms of our investments;
•our ability to obtain, maintain, repay or refinance financing arrangements, including securitizations;
•market conditions and our ability to access alternative debt markets and additional debt and equity capital;
•the amount of commercial mortgage loans requiring refinancing;
•the demand for commercial real estate loans;
•our expected investment capacity and available capital;
•financing and advance rates for our target investments;
•our expected leverage;
•changes in interest rates, credit spreads and the market value of our investments;
•the impact of the replacement of the London Interbank Offered Rate (“LIBOR”) on our operating results;
•effects of hedging instruments on our target investments;
•rates of default or decreased recovery rates on our target investments;
•rates of prepayments on our mortgage loans and the effect on our business of such prepayments;
•the degree to which our hedging strategies may or may not protect us from interest rate volatility;
•availability of investment opportunities in mortgage-related and real estate-related investments and securities;
•the ability of Ares Commercial Real Estate Management LLC (“ACREM” or our “Manager”) to locate suitable investments for us, monitor, service and administer our investments and execute our investment strategy;
•allocation of investment opportunities to us by our Manager;
•our ability to successfully identify, complete and integrate any acquisitions;
•our ability to maintain our qualification as a real estate investment trust (“REIT”) for United States federal income tax purposes;
•our ability to maintain our exemption from registration under the Investment Company Act of 1940 (the “1940 Act”);
•our understanding of our competition;
•general volatility of the securities markets in which we may invest;
•adverse changes in the real estate, real estate capital and credit markets and the impact of a protracted decline in the liquidity of credit markets on our business;
•changes in governmental regulations, tax law and rates, and similar matters (including interpretation thereof);
•authoritative or policy changes from standard-setting bodies such as the Financial Accounting Standards Board, the Securities and Exchange Commission, the Internal Revenue Service, the stock exchange where we list our common stock, and other authorities that we are subject to, as well as their counterparts in any foreign jurisdictions where we might do business;
•actions and initiatives of the United States Government or governments outside of the United States, and changes to United States Government policies;
•the state of the United States, European Union and Asian economies generally or in specific geographic regions;
•global economic trends and economic conditions; and
•market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy.
We use words such as “anticipates,” “believes,” “expects,” “intends,” “will,” “should,” “may” and similar expressions to identify forward-looking statements, although not all forward-looking statements include these words. Our actual results and condition could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth in “Risk Factors” and the other information included in our annual report on Form 10-K and elsewhere in this quarterly report on Form 10-Q.
We have based the forward-looking statements included in this quarterly report on information available to us on the date of this quarterly report, and we assume no obligation to update any such forward-looking statements. Although we
undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we have filed or in the future may file with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, registration statements on Form S-3, quarterly reports on Form 10-Q and current reports on Form 8-K.
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)
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| As of |
| September 30, 2021 | | December 31, 2020 |
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| (unaudited) | | |
ASSETS | | | |
Cash and cash equivalents | $ | 15,787 | | | $ | 74,776 | |
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Loans held for investment ($1,135,660 and $550,590 related to consolidated VIEs, respectively) | 2,363,499 | | | 1,815,219 | |
Current expected credit loss reserve | (22,691) | | | (23,604) | |
Loans held for investment, net of current expected credit loss reserve | 2,340,808 | | | 1,791,615 | |
| | | |
Real estate owned, net | 36,695 | | | 37,283 | |
Other assets ($2,524 and $1,079 of interest receivable related to consolidated VIEs, respectively; $47,618 and $6,410 of other receivables related to consolidated VIEs, respectively) | 73,395 | | | 25,823 | |
Total assets | $ | 2,466,685 | | | $ | 1,929,497 | |
LIABILITIES AND STOCKHOLDERS' EQUITY | | | |
LIABILITIES | | | |
Secured funding agreements | $ | 656,014 | | | $ | 755,552 | |
Notes payable | 47,381 | | | 61,837 | |
Secured term loan | 60,000 | | | 110,000 | |
Collateralized loan obligation securitization debt (consolidated VIEs) | 940,133 | | | 443,871 | |
Secured borrowings | 59,962 | | | 59,790 | |
Due to affiliate | 3,947 | | | 3,150 | |
Dividends payable | 16,523 | | | 11,124 | |
Other liabilities ($549 and $391 of interest payable related to consolidated VIEs, respectively) | 9,982 | | | 11,158 | |
Total liabilities | 1,793,942 | | | 1,456,482 | |
Commitments and contingencies (Note 9) | | | |
STOCKHOLDERS' EQUITY | | | |
Common stock, par value $0.01 per share, 450,000,000 shares authorized at September 30, 2021 and December 31, 2020 and 47,001,821 and 33,442,332 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively | 464 | | | 329 | |
Additional paid-in capital | 701,370 | | | 497,803 | |
Accumulated other comprehensive income | 19 | | | — | |
Accumulated earnings (deficit) | (29,110) | | | (25,117) | |
Total stockholders' equity | 672,743 | | | 473,015 | |
Total liabilities and stockholders' equity | $ | 2,466,685 | | | $ | 1,929,497 | |
See accompanying notes to consolidated financial statements.
ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
| | | | | | | | | | | | | | | | | | | | | | | | | |
| For the three months ended September 30, | | For the nine months ended September 30, |
| 2021 | | 2020 | | 2021 | | 2020 | | |
| (unaudited) | | (unaudited) | | (unaudited) | | (unaudited) | | |
Revenue: | | | | | | | | | |
Interest income | $ | 34,023 | | | $ | 30,626 | | | $ | 95,587 | | | $ | 91,908 | | | |
Interest expense | (12,669) | | | (11,875) | | | (35,900) | | | (40,450) | | | |
Net interest margin | 21,354 | | | 18,751 | | | 59,687 | | | 51,458 | | | |
Revenue from real estate owned | 5,850 | | | 3,623 | | | 12,271 | | | 10,032 | | | |
Total revenue | 27,204 | | | 22,374 | | | 71,958 | | | 61,490 | | | |
Expenses: | | | | | | | | | |
Management and incentive fees to affiliate | 3,175 | | | 1,847 | | | 8,693 | | | 5,771 | | | |
Professional fees | 480 | | | 639 | | | 1,880 | | | 2,202 | | | |
General and administrative expenses | 1,119 | | | 969 | | | 3,470 | | | 2,797 | | | |
General and administrative expenses reimbursed to affiliate | 773 | | | 802 | | | 2,313 | | | 2,890 | | | |
Expenses from real estate owned | 5,339 | | | 4,046 | | | 12,458 | | | 13,976 | | | |
Total expenses | 10,886 | | | 8,303 | | | 28,814 | | | 27,636 | | | |
Provision for current expected credit losses | 6,367 | | | (1,048) | | | (756) | | | 22,063 | | | |
Realized losses on loans sold | — | | | 4,008 | | | — | | | 4,008 | | | |
Change in unrealized losses on loans held for sale | — | | | (3,998) | | | — | | | — | | | |
Income before income taxes | 9,951 | | | 15,109 | | | 43,900 | | | 7,783 | | | |
Income tax expense, including excise tax | — | | | 181 | | | 593 | | | 350 | | | |
Net income attributable to common stockholders | $ | 9,951 | | | $ | 14,928 | | | $ | 43,307 | | | $ | 7,433 | | | |
Earnings per common share: | | | | | | | | | |
Basic earnings per common share | $ | 0.21 | | | $ | 0.45 | | | $ | 1.06 | | | $ | 0.23 | | | |
Diluted earnings per common share | $ | 0.21 | | | $ | 0.44 | | | $ | 1.05 | | | $ | 0.22 | | | |
Weighted average number of common shares outstanding: | | | | | | | | | |
Basic weighted average shares of common stock outstanding | 46,957,339 | | | 33,337,445 | | | 40,840,453 | | | 32,852,553 | | | |
Diluted weighted average shares of common stock outstanding | 47,209,469 | | | 33,550,444 | | | 41,120,751 | | | 33,072,085 | | | |
Dividends declared per share of common stock | $ | 0.35 | | | $ | 0.33 | | | $ | 1.05 | | | $ | 0.99 | | | |
See accompanying notes to consolidated financial statements.
ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
| | | | | | | | | | | | | | | | | | | | | | | | | |
| For the three months ended September 30, | | For the nine months ended September 30, |
| 2021 | | 2020 | | 2021 | | 2020 | | |
| (unaudited) | | (unaudited) | | (unaudited) | | (unaudited) | | |
Net income attributable to common stockholders | $ | 9,951 | | | $ | 14,928 | | | $ | 43,307 | | | $ | 7,433 | | | |
Other comprehensive income: | | | | | | | | | |
Unrealized gains (losses) on derivative financial instruments | (98) | | | — | | | 19 | | | — | | | |
Comprehensive income | $ | 9,853 | | | $ | 14,928 | | | $ | 43,326 | | | $ | 7,433 | | | |
See accompanying notes to consolidated financial statements.
ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share and per share data)
(unaudited)
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Common Stock | | Additional Paid-in Capital | | Accumulated Other Comprehensive Income | | Accumulated Earnings (Deficit) | | Total Stockholders’ Equity |
| Shares | | Amount | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
Balance at December 31, 2019 | 28,865,610 | | | $ | 283 | | | $ | 423,619 | | | $ | — | | | $ | 2,437 | | | $ | 426,339 | |
Sale of common stock | 4,600,000 | | | 46 | | | 73,186 | | | — | | | — | | | 73,232 | |
Offering costs | — | | | — | | | (341) | | | — | | | — | | | (341) | |
Stock-based compensation | (66,658) | | | — | | | 225 | | | — | | | — | | | 225 | |
Net loss | — | | | — | | | — | | | — | | | (17,263) | | | (17,263) | |
Dividends declared | — | | | — | | | — | | | — | | | (11,076) | | | (11,076) | |
Impact of adoption of CECL (Note 2) | — | | | — | | | — | | | — | | | (5,051) | | | (5,051) | |
Balance at March 31, 2020 | 33,398,952 | | | $ | 329 | | | $ | 496,689 | | | $ | — | | | $ | (30,953) | | | $ | 466,065 | |
Stock-based compensation | 42,985 | | | — | | | 365 | | | — | | | — | | | 365 | |
Net income | — | | | — | | | — | | | — | | | 9,768 | | | 9,768 | |
Dividends declared | — | | | — | | | — | | | — | | | (11,072) | | | (11,072) | |
Balance at June 30, 2020 | 33,441,937 | | | $ | 329 | | | $ | 497,054 | | | $ | — | | | $ | (32,257) | | | $ | 465,126 | |
Stock-based compensation | — | | | — | | | 367 | | | — | | | — | | | 367 | |
Net income | — | | | — | | | — | | | — | | | 14,928 | | | 14,928 | |
Dividends declared | — | | | — | | | — | | | — | | | (11,072) | | | (11,072) | |
Balance at September 30, 2020 | 33,441,937 | | | $ | 329 | | | $ | 497,421 | | | $ | — | | | $ | (28,401) | | | $ | 469,349 | |
Stock-based compensation | 395 | | | — | | | 382 | | | — | | | — | | | 382 | |
Net income | — | | | — | | | — | | | — | | | 14,407 | | | 14,407 | |
Dividends declared | — | | | — | | | — | | | — | | | (11,123) | | | (11,123) | |
Balance at December 31, 2020 | 33,442,332 | | | $ | 329 | | | $ | 497,803 | | | $ | — | | | $ | (25,117) | | | $ | 473,015 | |
Sale of common stock | 7,000,000 | | | 70 | | | 100,800 | | | — | | | — | | | 100,870 | |
Offering costs | — | | | — | | | (188) | | | — | | | — | | | (188) | |
Stock-based compensation | 35,509 | | | — | | | 521 | | | — | | | — | | | 521 | |
Other comprehensive income | — | | | — | | | — | | | 263 | | | — | | | 263 | |
Net income | — | | | — | | | — | | | — | | | 15,740 | | | 15,740 | |
Dividends declared | — | | | — | | | — | | | — | | | (14,248) | | | (14,248) | |
Balance at March 31, 2021 | 40,477,841 | | | $ | 399 | | | $ | 598,936 | | | $ | 263 | | | $ | (23,625) | | | $ | 575,973 | |
Sale of common stock | 6,500,000 | | | 65 | | | 101,725 | | | — | | | — | | | 101,790 | |
Offering costs | — | | | — | | | (164) | | | — | | | — | | | (164) | |
Stock-based compensation | 23,280 | | | — | | | 497 | | | — | | | — | | | 497 | |
Other comprehensive income | — | | | — | | | — | | | (146) | | | — | | | (146) | |
Net income | — | | | — | | | — | | | — | | | 17,615 | | | 17,615 | |
Dividends declared | — | | | — | | | — | | | — | | | (16,528) | | | (16,528) | |
Balance at June 30, 2021 | 47,001,121 | | | $ | 464 | | | $ | 700,994 | | | $ | 117 | | | $ | (22,538) | | | $ | 679,037 | |
Offering costs | — | | | — | | | (52) | | | — | | | — | | | (52) | |
Stock-based compensation | 700 | | | — | | | 428 | | | — | | | — | | | 428 | |
Other comprehensive income | — | | | — | | | — | | | (98) | | | — | | | (98) | |
Net income | — | | | — | | | — | | | — | | | 9,951 | | | 9,951 | |
Dividends declared | — | | | — | | | — | | | — | | | (16,523) | | | (16,523) | |
Balance at September 30, 2021 | 47,001,821 | | | $ | 464 | | | $ | 701,370 | | | $ | 19 | | | $ | (29,110) | | | $ | 672,743 | |
See accompanying notes to consolidated financial statements.
ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
| | | | | | | | | | | | | |
| For the nine months ended September 30, |
| 2021 | | 2020 | | |
| (unaudited) | | (unaudited) | | |
Operating activities: | | | | | |
Net income | $ | 43,307 | | | $ | 7,433 | | | |
Adjustments to reconcile net income to net cash provided by (used in) operating activities: | | | | | |
Amortization of deferred financing costs | 7,111 | | | 4,906 | | | |
Accretion of deferred loan origination fees and costs | (5,979) | | | (5,732) | | | |
Stock-based compensation | 1,446 | | | 956 | | | |
Depreciation of real estate owned | 674 | | | 668 | | | |
Provision for current expected credit losses | (756) | | | 22,063 | | | |
Realized losses on loans sold | — | | | 4,008 | | | |
| | | | | |
Changes in operating assets and liabilities: | | | | | |
Other assets | (16,728) | | | (9,302) | | | |
Due to affiliate | 797 | | | (91) | | | |
Other liabilities | 408 | | | (2,165) | | | |
Net cash provided by (used in) operating activities | 30,280 | | | 22,744 | | | |
Investing activities: | | | | | |
Issuance of and fundings on loans held for investment | (877,950) | | | (485,913) | | | |
Principal repayment of loans held for investment | 299,021 | | | 280,318 | | | |
Proceeds from sale of loans held for sale | — | | | 96,597 | | | |
Receipt of origination fees | 4,636 | | | 3,978 | | | |
Purchases of capitalized additions to real estate owned | (86) | | | (243) | | | |
Payments under derivative financial instruments | (700) | | | — | | | |
Net cash provided by (used in) investing activities | (575,079) | | | (105,263) | | | |
Financing activities: | | | | | |
Proceeds from secured funding agreements | 611,515 | | | 466,778 | | | |
Repayments of secured funding agreements | (711,054) | | | (404,231) | | | |
Proceeds from notes payable | 13,008 | | | 3,000 | | | |
Repayments of notes payable | (27,880) | | | — | | | |
Repayments of secured term loan | (50,000) | | | — | | | |
Proceeds from secured borrowings | — | | | 55,095 | | | |
Payment of secured funding costs | (9,734) | | | (3,700) | | | |
Proceeds from issuance of debt of consolidated VIEs | 540,471 | | | — | | | |
Repayments of debt of consolidated VIEs | (40,982) | | | — | | | |
Dividends paid | (41,901) | | | (31,694) | | | |
Proceeds from sale of common stock | 202,660 | | | 73,232 | | | |
Payment of offering costs | (293) | | | (301) | | | |
Net cash provided by (used in) financing activities | 485,810 | | | 158,179 | | | |
Change in cash and cash equivalents | (58,989) | | | 75,660 | | | |
Cash and cash equivalents, beginning of period | 74,776 | | | 5,635 | | | |
Cash and cash equivalents, end of period | $ | 15,787 | | | $ | 81,295 | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
See accompanying notes to consolidated financial statements.
ARES COMMERCIAL REAL ESTATE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of September 30, 2021
(in thousands, except share and per share data, percentages and as otherwise indicated)
(unaudited)
1. ORGANIZATION
Ares Commercial Real Estate Corporation (together with its consolidated subsidiaries, the “Company” or “ACRE”) is a specialty finance company primarily engaged in originating and investing in commercial real estate loans and related investments. 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 Corporation (NYSE: ARES) (“Ares Management” or “Ares”), a publicly traded, leading global alternative investment manager, it has investment professionals strategically located across the United States and Europe 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 (the “Management Agreement”).
The Company operates as one operating segment and is primarily focused on directly originating and managing a diversified portfolio of CRE debt-related investments for the Company’s own account. The Company’s target investments include senior mortgage loans, subordinated debt, preferred equity, mezzanine loans and other CRE investments, including commercial mortgage backed securities. These investments are generally held for investment and are secured, directly or indirectly, by office, multifamily, retail, industrial, lodging, self storage, student housing, residential, senior-living and other commercial real estate properties, or by ownership interests therein.
The Company has elected and qualified to be taxed as a real estate investment trust (“REIT”) for United States federal income tax purposes under the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2012. The Company generally will not be subject to United States federal income taxes on its REIT taxable income as long as it annually distributes all of its REIT taxable income prior to the deduction for dividends paid to stockholders and complies with various other requirements as a REIT.
2. SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited consolidated interim financial statements should be read in conjunction with the audited consolidated financial statements and the related management's discussion and analysis of financial condition and results of operations included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2020 filed with the SEC.
Refer to the Company’s Annual Report on Form 10-K for a description of the Company’s recurring accounting policies. The Company has included disclosure below regarding basis of presentation and other accounting policies that (i) are required to be disclosed quarterly or (ii) the Company views as critical as of the date of this report.
Basis of Presentation
The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with United States generally accepted accounting principles (“GAAP”) and include the accounts of the Company, the consolidated variable interest entities (“VIEs”) that the Company controls and of which the Company is the primary beneficiary, and the Company’s 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 GAAP 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, 2021.
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. As of the filing date of this Quarterly Report, there is a continued outbreak of the novel coronavirus (“COVID-19”) pandemic, for which the World Health Organization has declared a global pandemic, the United States has declared a national emergency and every state in the United States is under a federal disaster declaration. Many states, including those in which the Company and its borrowers operate, have issued orders requiring the closure of, or certain restrictions on the operation of, non-essential businesses and/or requiring residents to stay at home. The COVID-19 pandemic and preventative measures taken to contain or mitigate its spread have caused, and are continuing to cause, business shutdowns or the re-introduction of business shutdowns, cancellations of events and restrictions on travel, significant reductions in demand for certain goods and services, reductions in business activity and financial transactions and overall economic and financial market instability both globally and in the United States. The COVID-19 pandemic continues to disrupt global supply chains, has caused labor shortages and has added broad inflationary pressures, which has the potential to negatively impact the Company and its borrowers. While several countries, as well as certain states in the United States, have relaxed the public health restrictions with a view to partially or fully reopen their economies, recurring COVID-19 outbreaks, including outbreaks of several variants of COVID-19, such as the Delta variant, have led to the re-introduction of such restrictions in certain states in the United States and globally and could continue to lead to the re-introduction of such restrictions elsewhere.
Additionally, in December 2020, the U.S. Food and Drug Administration authorized certain vaccines for emergency use, which are currently being distributed nationwide and globally. However, it remains unclear how quickly “herd immunity” will be achieved and the restrictions that were imposed to slow the spread of the virus will be lifted entirely. These uncertainties could lead the public to continue to self-isolate and not participate in the economy at pre-pandemic levels for a prolonged period of time. Additionally, concerns about the long-term effects of the vaccines could discourage people from obtaining a vaccine. Even after the COVID-19 pandemic subsides, the U.S. economy and most other major global economies may experience a recession, and we anticipate our business and operations could be materially adversely affected by a prolonged recession in the United States. The Company believes the estimates and assumptions underlying its consolidated financial statements are reasonable and supportable based on the information available as of September 30, 2021, however, uncertainty over the ultimate impact the COVID-19 pandemic will have on the global economy and the Company’s business, makes any estimates and assumptions as of September 30, 2021 inherently less certain than they would be absent the current and potential impacts of the COVID-19 pandemic. Actual results could differ from those estimates.
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, 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.
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 of 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 cause the Company’s consolidation conclusion regarding the VIE to change. See Note 16 included in these consolidated financial statements for further discussion of the Company’s VIEs.
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.
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 (the “carrying value”). Loans are generally 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 loans held for 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 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.
Loans are generally placed on non-accrual status when principal or interest payments are past due 30 days or more or when there is reasonable doubt that principal or interest will be collected in full. Accrued and unpaid interest is generally reversed against interest income in the period the loan is placed on non-accrual status. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management’s judgment regarding the borrower’s ability to make pending principal and interest payments. Non-accrual loans are restored to accrual status when past due principal and interest are paid and, in management’s judgment, are likely to remain current. The Company may make exceptions to placing a loan on non-accrual status if the loan has sufficient collateral value and is in the process of collection.
Loan balances that are deemed to be uncollectible are written off as a realized loss and are deducted from the current expected credit loss reserve. The write-offs are recorded in the period in which the loan balance is deemed uncollectible based on management’s judgment.
Current Expected Credit Losses
Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires the Company to reflect current expected credit losses (“CECL”) on both the outstanding balances and unfunded commitments on loans held for investment and requires consideration of a broad range of historical experience adjusted for current conditions and reasonable and supportable forecast information to inform credit loss estimates (the “CECL Reserve”). ASU No. 2016-13 was effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period. ASU No. 2016-13 was adopted by the Company on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of January 1, 2020. Subsequent period increases and decreases to expected credit losses impact earnings and are recorded within provision for current expected credit losses in the Company’s consolidated statements of operations. The CECL Reserve related to outstanding balances on loans held for investment required under ASU No. 2016-13 is a valuation account that is deducted from the amortized cost basis of the Company’s loans held for investment in the Company’s consolidated balance sheets. The CECL Reserve related to unfunded commitments on loans held for investment is recorded within other liabilities in the Company's consolidated balance sheets. See Note 4 included in these consolidated financial statements for CECL related disclosures.
Real Estate Owned
Real estate assets are carried at their estimated fair value at acquisition and are presented net of accumulated depreciation and impairment charges. The Company allocates the purchase price of acquired real estate assets based on the fair value of the acquired land, building, furniture, fixtures and equipment.
Real estate assets are depreciated using the straight-line method over estimated useful lives of up to 40 years for buildings and improvements and up to 15 years for furniture, fixtures and equipment. Renovations and/or replacements that improve or extend the life of the real estate asset are capitalized and depreciated over their estimated useful lives. The cost of ordinary repairs and maintenance are expensed as incurred.
Real estate assets are evaluated for indicators of impairment on a quarterly basis. Factors that the Company may consider in its impairment analysis include, among others: (1) significant underperformance relative to historical or anticipated operating results; (2) significant negative industry or economic trends; (3) costs necessary to extend the life or improve the real estate asset; (4) significant increase in competition; and (5) ability to hold and dispose of the real estate asset in the ordinary course of business. A real estate asset is considered impaired when the sum of estimated future undiscounted cash flows expected to be generated by the real estate asset over the estimated remaining holding period is less than the carrying amount of such real estate asset. Cash flows include operating cash flows and anticipated capital proceeds generated by the real estate asset. An impairment charge is recorded equal to the excess of the carrying value of the real estate asset over the fair value. When determining the fair value of a real estate asset, the Company makes certain assumptions including, but not limited to, consideration of projected operating cash flows, comparable selling prices and projected cash flows from the eventual disposition of the real estate asset based upon the Company’s estimate of a capitalization rate and discount rate.
The Company reviews its real estate assets, from time to time, in order to determine whether to sell such assets. Real estate assets are classified as held for sale when the Company commits to a plan to sell the asset, when the asset is being actively marketed for sale at a reasonable price and the sale of the asset is probable and the transfer of the asset is expected to qualify for recognition as a completed sale within one year. Real estate assets that are held for sale are carried at the lower of the asset’s carrying amount or its fair value less costs to sell.
Debt Issuance Costs
Debt issuance costs under the Company’s indebtedness are capitalized and amortized over the term of the respective debt instrument. Unamortized debt issuance costs are expensed when the associated debt is repaid prior to maturity. 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 and the outstanding principal balance of the securitization debt is reduced, 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 within interest expense, except as noted below, in the Company’s consolidated statements of operations while the unamortized balance on (i) Secured Funding Agreements (each individually defined in Note 6 included in these consolidated financial statements) is included within other assets and (ii) Notes Payable, the Secured Term Loan (each defined in Note 6 included in these consolidated financial statements) and Secured Borrowings (defined in Note 7 included in these consolidated financial statements) and debt securitizations are each included as a reduction to the carrying amount of the liability, in the Company’s consolidated balance sheets. Amortization of debt issuance costs for the note payable on the hotel property that is recognized as
real estate owned in the Company’s consolidated balance sheets (see Note 6 included in these consolidated financial statements for additional information on the note payable) is included within expenses from real estate owned in the Company’s consolidated statements of operations.
Derivative Financial Instruments
Derivative financial instruments are classified as either other assets (gain positions) or other liabilities (loss positions) in the Company’s consolidated balance sheets at fair value. These amounts may be offset to the extent that there is a legal right to offset and if elected by management.
On the date the Company enters into a derivative contract, the Company designates each contract as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability, or cash flow hedge, or as a derivative instrument not to be designated as a hedging derivative, or non-designated hedge. For all derivatives other than those designated as non-designated hedges, the Company formally documents the hedge relationships and designation at the contract’s inception. This documentation includes the identification of the hedging instruments and the hedged items, its risk management objectives, strategy for undertaking the hedge transaction and an evaluation of the effectiveness of its hedged transaction.
The Company performs a formal assessment on a quarterly basis on whether the derivative designated in each hedging relationship is expected to be, and has been, highly effective in offsetting changes in the value or cash flows of the hedged items. Changes in the fair value of derivative contracts are recorded each period in either current earnings or other comprehensive income (“OCI”), depending on whether the derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For derivatives that are designated as cash flow hedges, the effective portion of the unrealized gains or losses on these contracts is recorded in OCI. If it is determined that a derivative is not highly effective at hedging the designated exposure, hedge accounting is discontinued and the changes in fair value of the instrument are included in current earnings prospectively. The Company does not enter into derivatives for trading or speculative purposes.
Revenue Recognition
Interest income is accrued based on the outstanding principal amount and the contractual terms of each loan. For loans held for investment, the origination fees, contractual exit fees and direct loan origination costs are also recognized in interest income over the initial loan term as a yield adjustment using the effective interest method.
Revenue from real estate owned represents revenue associated with the operations of a hotel property classified as real estate owned. Revenue from the operation of the hotel property is recognized when guestrooms are occupied, services have been rendered or fees have been earned. Revenues are recorded net of any discounts and sales and other taxes collected from customers. Revenues consist of room sales, food and beverage sales and other hotel revenues.
Net Interest Margin and Interest Expense
Net interest margin in the Company’s consolidated statements of operations serves to measure the performance of the Company’s loans as compared to its use of debt leverage. The Company includes interest income from its loans and interest expense related to its Secured Funding Agreements, Notes Payable, securitization debt, the Secured Term Loan (each individually defined in Note 6 included in these consolidated financial statements) and Secured Borrowings (defined in Note 7 included in these consolidated financial statements) in net interest margin. For the three and nine months ended September 30, 2021 and 2020, interest expense is comprised of the following ($ in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | |
| For the three months ended September 30, | | For the nine months ended September 30, |
| 2021 | | 2020 | | 2021 | | 2020 | | |
Secured funding agreements | $ | 4,308 | | | $ | 6,000 | | | $ | 11,327 | | | $ | 22,447 | | | |
Notes payable (1) | 368 | | | 337 | | | 1,841 | | | 952 | | | |
Securitization debt | 5,414 | | | 2,518 | | | 14,858 | | | 9,879 | | | |
Secured term loan | |