Ares Commercial Real Estate - Q4 2023

Transcript

Operator (participant)

Good morning. Welcome to Ares Commercial Real Estate Corporation's fourth quarter and year-end December 31, 2023 earnings conference call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Thursday, February 22, 2024. I will now turn the call over to Mr. John Stilmar, partner of Public Markets Investor Relations.

John Stilmar (Partner of Public Markets Investor Relations)

Good morning, and thank you for joining us on today's conference call. I'm joined today by our CEO, Bryan Donohoe, our CFO, Tae-Sik Yoon, and other members of the management team. In addition to our press release and the 10-K that we filed with the SEC, we've posted an earnings presentation under the Investor Resources section of our website at www.arescre.com. Before we begin, I want to remind everyone that comments made during the course of this conference call and webcast, as well as accompanying documents, contain forward-looking statements that are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may, and similar such expressions. These forward-looking statements are based on management's current expectations of market conditions and management's judgment.

These statements are not guarantees of future performance, condition, or results, and involve a number of risks and uncertainties. The company's actual results could differ materially from those expressed in the forward-looking statements as a result of a number of factors including those listed in its SEC filing. Ares Commercial Real Estate assumes no obligation to update any such forward-looking comments. During this conference call, we'll refer to certain non-GAAP financial measures. We use these as measures of operating performance. These measures should not be considered in isolation from or to substitute for measures prepared in accordance with generally accepted accounting principles. These measures may not be comparable to like-titled measures used by other companies. Now, I'd like to turn the call over to our CEO, Bryan Donohoe. Bryan?

Bryan Donohoe (CEO)

Thanks, John. Good morning, everyone, and thank you for joining our fourth quarter 2023 earnings call. As I'm sure you're aware, we continue to see higher interest rates, higher rates of inflation, as well as certain cultural shifts such as work-from-home trends adversely impacting the operating performance and economic values of commercial real estate. This is particularly evident from many office properties. In addition, many properties requiring significant capital expenditures have been impacted by higher labor and material costs. Unfortunately, we are not immune to these macroeconomic challenges, and our results for 2023 and the fourth quarter are partially a reflection of these conditions.

For the fourth quarter, we had a GAAP loss of $0.73 per common share, driven by a $47 million or $0.87 per common share increase in our CECL reserve, most of which is related to loans collateralized by office properties or a residential condominium construction project. In addition, for the fourth quarter, we placed six additional loans on non-accrual status, which impacted both our GAAP and distributable earnings by approximately $0.12 per common share versus what these six loans contributed in the third quarter of 2023. As a result, our distributable earnings for the fourth quarter were $0.20 per common share. Fortunately, we're starting to see some positive trends in the macroeconomic environment that we believe are likely to benefit commercial real estate, including the potential for declining short-term interest rates.

Specifically, declining spreads on CMBS and CRE CLOs, particularly during the past six months, reflect strengthened capital markets conditions. Positive leasing momentum in certain sectors, including industrial and self-storage, and continued healthy demand trends for multifamily assets underscore some of the opportunities we see in today's market. These trends play out across our portfolio, particularly for loans that are risk-rated one to three, which total about $1.6 billion in outstanding principal balance. This risk-rated one through three portfolio is focused on senior, first-lien positions and is diversified across 37 loans. The majority of these loans are collateralized by multifamily, industrial, and self-storage properties, with the largest focus on multifamily properties at 34%. As a positive indication of borrowers' commitment to the properties, they contributed more than $150 million of capital, representing about 10% of the $1.6 billion in principal balance of these loans.

A portion of this $150 million was used to renew all interest rate caps that expired in 2023 at their prior strike rate or at an economically equivalent amount after considering additional reserves. Let's now turn to our strategic plan to resolve the nine remaining risk-rated four or five loans that comprise about $539 million in outstanding principal balance and one loan held for sale with a carrying value of $39 million as of year-end 2023. As we mentioned, these loans are primarily collateralized by office properties and one residential condo property. First, we will fully leverage the management capabilities of the Ares Real Estate Group. As we have discussed previously, Ares Real Estate Group has more than 250 investment professionals and currently manages more than 500 investments globally, totaling approximately $50 billion in assets under management. We intend to use these capabilities to resolve underperforming loans held by ACRE.

Second, we have built significant loss reserves against these four and five risk-rated loans. As of December 31, 2023, 91% of our total $163 million in CECL reserve, or $149 million, is related to these nine loans, which is about 28% of the $539 million in outstanding principal balance for these loans. Finally, we have been highly purposeful in positioning our balance sheet over the past few years to provide us with greater flexibility and time to resolve these underperforming loans. For example, our net debt to equity has declined from 2.6x at year-end 2021 to 1.9x at year-end 2023, in both cases before the impact of CECL reserves on our shareholder equity. In addition, we have accumulated additional available capital, which totaled $185 million.

All of these measures and capabilities have positioned us to work through our underperforming loans while balancing the goals of maximizing proceeds and accelerating the time frame for resolution. So far, we have made some notable progress towards these goals. First, at the end of January 2024, we successfully sold the $39 million senior loan held for sale at a price equal to its year-end 2023 carrying value. Second, although we did not close on the sale of the office property in Illinois that backed our $57 million senior loan before year-end 2023, our borrower is under an agreement to sell the underlying property in the coming weeks. Third, we are working diligently to resolve three additional loans in the next few months. One loan will likely be resolved through the sale of the underlying property.

The other two may involve restructuring the terms of the loan so that we can return a significant portion of the principal balance to accrual status, including having the borrower contribute additional capital to the properties. Now, let me provide some additional background on our dividend of $0.25 per share that our board of directors has declared for the first quarter of 2024. Since our initial public offering nearly 12 years ago, we have operated with a framework that considers our distributable earnings power when setting the quarterly dividend. Up until this time, we have not reduced or delayed our quarterly dividend. In fact, we provided $0.02 per share in supplemental dividends for 10 quarters.

In this current market environment, however, we believe it is in the best interests of ACRE and its stakeholders to reduce the quarterly dividend to help preserve book value and liquidity and to pay out an amount more in line with our expected near-term quarterly distributable earnings before realized losses. Ultimately, as we get through this cycle that we execute on our earnings opportunities as discussed, we expect we can return to high levels of profitability. With that, let me turn the call over to Tae-Sik.

Tae-Sik Yoon (CFO)

Thank you, Bryan, and good morning, everyone. For the fourth quarter of 2023, we've reported a GAAP net loss of $39.4 million or $0.73 per common share. As Bryan mentioned, our GAAP net income was adversely impacted by a $47.5 million increase in our CECL provision, or about $0.87 per common share. For full year 2023, we reported a GAAP net loss of $38.9 million or $0.72 per common share and distributable earnings of $58.4 million or $1.06 per common share. Our book value per common share now stands at $11.56 or $14.57, excluding the $3.01 per share CECL reserves. Distributable earnings for the fourth quarter of 2023 was $10.8 million or $0.20 per common share, which was adversely impacted by the six additional loans that were placed on non-accrual in the fourth quarter.

Our overall CECL reserve now stands at $163 million, representing 7.6% of the outstanding principal balance of our loans held for investment. 91% of our total $163 million in CECL reserve, or $149 million, relates to our risk-rated four and five loans, including $57 million of loss reserves on our three risk-rated five loans and $92 million of loss reserves on our six risk-rated four loans. Overall, the $149 million of reserves represent 28% of the outstanding principal balance of risk-rated four and five loans held for investment. We continue to further bolster our liquidity and capital position. We maintain significant liquidity and a moderate net debt to equity ratio of 1.9 times at year-end 2023, including adding back our CECL reserves to shareholder equity. Our financing sources are diverse and, importantly, have no spread-based mark-to-market provisions.

On December 31, 2023, we had over $185 million in cash and undrawn availability under our working capital facility. This amount does not include other potential sources of additional capital, including unlevered loans and properties. During the year, our liquidity was further supported by $218 million of repayments and loan sales. Our net realized losses for 2023 was $10.5 million. Since our IPO in 2012, we have closed over $8 billion in commercial real estate loans and, through December 31, 2023, have recognized a total of $14.5 million in realized losses. Finally, as Bryan mentioned, we declared a regular cash dividend of $0.25 per common share for the first quarter of 2024. This first-quarter dividend will be payable on April 16, 2024, to common stockholders of record as of March 28, 2024. With that, I will turn the call back over to Bryan for some closing remarks.

Bryan Donohoe (CEO)

Thank you, Tae-Sik. We recognize the challenges that we face with these new non-accrual loans and the impact that they had on our financial results for the fourth quarter. Based on the progress that we are making with respect to these new problem loans, we do expect to improve our run-rate distributable earnings in the near term as we seek to recapture a portion of the lost earnings that we experienced in our fourth quarter. Our new quarterly dividend of $0.25 per share reflects our go-forward review of our near-term quarterly run-rate distributable earnings, excluding losses, assuming we achieve the earnings enhancements from our contemplated resolutions. Longer term, we believe the real estate capabilities we possess at Ares, coupled with our capital, liquidity, and reserves, will enable us to maximize credit outcomes and enhance our earnings from these situations.

We are cautiously optimistic that the increasing level of transaction activity and improving equity will provide more confidence for market participants over time, conditioning us to return to a higher level of earnings in the future. Call today, and we'd be happy to open the line for questions. Operator?

Operator (participant)

At this time, if you would like to ask a question, please press star, then one on your telephone keypad. If you would like to withdraw your question, please press star, then two. Thank you. We'll take a question from Sarah Barcomb.

Sarah Barcomb (VP of Equity Research)

Hey, good morning, everyone. Thank you for taking the question. Through your go-forward to this new $0.25 dividend. Just with the Q4 DE coming in closer to $0.20, I'm hoping you can help us bridge that gap for coverage.

Tae-Sik Yoon (CFO)

Thank you very much for your question, Sarah. As we mentioned on our prepared report, the impact of putting six had about a $0.12 impact from what those same loans earned in the third quarter. As Bryan also mentioned, we are working very hard to resolve a number of those loans, a number of those six new non-accrual loans that have been previously placed on non-accrual. I mentioned one of those loans, the $39 million loan held in California, that has been successfully resolved. As we continue to resolve additional loans, I think we're making good progress on resolving a number of those. Really, as we mentioned, kind of setting our dividend at the $0.25 level for the first quarter of 2024, we did take into account what we believe we can achieve in terms of distributable earnings once we're able to successfully resolve some of these loans.

So I think we are targeting to resolve some of these loans as soon as we can. And we do believe that once we are able to resolve these loans, then, as Bryan mentioned, the resolution will come in a couple of different forms. In some cases, a sale of the loan. In some cases, a sale of the underlying collateral. In some cases, restructuring of the loans with existing borrowers. So the resolutions are going to come in different forms. We do believe that our earnings power will go up. Rise in the fourth quarter of. By, again, the significant increase in non-accrual loans. So that is really our goal, is to resolve these loans and increase our earnings power so that we can continue to cover the dividend that we have set.

Sarah Barcomb (VP of Equity Research)

Looking at loan by loan, your expected resolutions there. So thanks for that. This one's a bit more backwards-looking, but I'm hoping you could walk us through what happened on the ground with those new non-accrual loans, whether it was an issue at the sponsor level with buying a new rate cap or something else, maybe leasing-related. Any color for us there?

Bryan Donohoe (CEO)

Yeah, a bit more color, Sarah. I would say that each was somewhat idiosyncratic, but certainly borrower behavior, shift in sentiment around an asset, and support for that asset, as well as just really crystallizing some of the valuations as we've seen a bit more activity through Q4. There was more data to point to, as well as certain events within each of these specific assets where the borrower's approach to continuing those payments was more in doubt. So nothing overarching, just a few events that made us revisit some of the approach.

Sarah Barcomb (VP of Equity Research)

Great. Thank you.

Bryan Donohoe (CEO)

Thanks, Sarah.

Operator (participant)

We'll take our next question from Stephen Laws of Raymond James.

Stephen Laws (Managing Director of Equity Research)

Hi, good morning. To follow up a little bit on Sarah's question, when you think about the potential earnings benefit as some of the non-accruals are resolved, is that really solely related to paying off the financing associated with these loans, or does it also include some assumptions around redeploying capital into new investments?

Tae-Sik Yoon (CFO)

Sure. Great question, Stephen. The answer really is it's a combination of a number of things, including the two examples that you mentioned. Yes, in some cases, the benefit that we would see in earnings comes from being able to pay down, either in part or in full, associated liability of some of the non-accrual loans. Clearly, the loans are already on non-accrual. Unfortunately, we are still paying interest on the associated liability. To the extent that we can use all these loans and get a full or partial repayment of the associated liability, that would obviously result in higher net income. The other, as you mentioned, is that some of the resolutions, we believe, will result in some net cash coming to us.

Again, we haven't really built in redeployment of that cash to necessarily increase earnings going forward, but we obviously can utilize that cash for a number of different purposes. I would say another example along the same line is that, again, as I mentioned, some of the resolutions we're working on is restructuring of the loan with the existing borrowers. We believe in some of those situations, we believe we can restructure the loan, which would potentially include some new cash from the borrower coming into the property and into the loan. That would then allow us to then begin to recognize interest on some or all of the existing loan itself. I think those are just three examples of how earnings can be increased going forward upon resolving some of these non-accrual loans.

That's not the exhaustive list, but I think those are three good examples of how resolving the loans can increase earnings going forward.

Stephen Laws (Managing Director of Equity Research)

Appreciate the color on that, Tae-Sik. To continue with interest income, were these six new non-accrual loans so non-accrual for the entire fourth quarter, or did they contribute some interest income in the early part of the quarter?

Tae-Sik Yoon (CFO)

Sure. Great question. I appreciate the distinction there. So our policy is that we put a loan on non-accrual for the entire quarter. So when we talk about the $0.12 impact, that meant that for the fourth quarter overall, for the entire fourth quarter, that these six loans did not recognize any interest revenue, interest income for the entirety of the fourth quarter.

Stephen Laws (Managing Director of Equity Research)

Okay. Thank you for clarifying that. And then as we think about the interest coverage test, I think it's a 12-month look back, but can you update us and apologies, I haven't had a chance to get through the whole filing this morning, but can you update us on where you stand on that, whether you'll need waivers for lower interest coverage test metrics, or how counterparty discussions are going around the developments with these loans?

Tae-Sik Yoon (CFO)

Sure. Stephen, I just want to clarify your question. When you say interest coverage test, are you talking about these specific loans, or are you talking about the company overall interest coverage?

Stephen Laws (Managing Director of Equity Research)

With your counterparties, I believe it's typically somewhere between a 1.3-1.5 interest coverage test with your bank lines or your other financing facilities and any debt covenants that need to be considered or discussed around these non-accrual developments.

Tae-Sik Yoon (CFO)

Sure. As you can imagine, we obviously have always closely monitored all of the covenants that we have on our own debt facilities, as well as those of the facility, as well as those where we hold as an asset. In terms of interest coverage, we are clearly meeting the interest coverage test in all of our debt facilities. I think one of the very proactive steps that we have taken now for the past several years is delevering our balance sheets, right? So we have about $1.6 billion of financing that is materially down from a couple of years ago. And so we have been very mindful of making sure that we have the right balance sheet in these more challenging market conditions. We have increased our liquidity. We have done a number of measures.

All of that has obviously helped, not only in terms of maintaining the flexibility and the balance sheet we need to work through some of the underperforming loans, but overall, it has put a little less stress on meeting our covenants. For example, if we were levered three to one, I think those coverage tests would be a bit tighter. As we mentioned, we have worked very hard to delever our balance sheet significantly over the past several years, and that has helped significantly on our loan covenants themselves.

Stephen Laws (Managing Director of Equity Research)

Great. Appreciate the comments this morning, and look forward to hearing about some of these resolutions in the next couple of quarters.

Operator (participant)

We'll take our next question from Rick Shane of JPMorgan.

Rick Shane (Managing Director)

Thanks, everybody, for taking my questions this morning. Most have really been asked, answered. But just want to make sure the loan that was held for sale sold at your carrying value, so no hit-to-book value, by our calculations, that represents about a $2.6 million realized loss. Is that correct?

Tae-Sik Yoon (CFO)

Yes. Good morning, Rick. We sold the loan, as we mentioned, at $39 million. And that is really a net proceed we received from the sale. And that was the stated fair value. One thing just to maybe distinguish here is that because we were under contract to sell this loan at year-end, we put this loan under available for sale. It was not held for investment. So it is not part of our held-for-investment portfolio. We did hold this at fair value, that fair value being the $39 million carrying value. And so there is no impact on book value, as you said. I forget the actual. I wasn't quite familiar with the $2.6 million you mentioned, but.

Rick Shane (Managing Director)

I was looking at the wrong loan. I apologize. You're going to give me a better number. I just did that up.

Tae-Sik Yoon (CFO)

Okay. Yeah. But no, I think the important point you're making is that, again, it was sold at its stated fair value at year-end, correct, at $39 million.

Rick Shane (Managing Director)

Got it. And when we look at the, call it, $150 million specific CECL reserve, should the assumption be, particularly because I think at this point you guys have incentive to resolve this quickly and be able to redeploy the capital in order to achieve the distributable earnings run rate that you're targeting, that you will realize that those losses will largely come through in the first half? The cadence of realized losses is going to be very front-loaded in 2024.

Tae-Sik Yoon (CFO)

Yeah. So maybe I can get in, Bryan. Please weigh in. Again, we go through our process to determine the appropriate amount of CECL reserve. I don't think it's necessarily reflective of what will ultimately be realized because in almost all situations, these are very dynamic markets. And so the realized losses could be more or could be less. In terms of timing, again, as we mentioned, we're working very hard on all of these loans. I think some are more near-term opportunities. Some are more opportunities that would come out in later quarters, later periods. I would not expect all of these to be realized in the first half, for example. I do think we are always balancing, as we say, maximizing proceeds as well as accelerating timeframe. But there is a balance between those two.

There are some situations where we feel holding on, if you want to call it, or maintaining our position for a little bit longer position results in greater value that we think it's worth doing. In some situations, we are pushing very hard to get something realized immediately because we don't think future value will be materially greater. So it's lots of different situations, but I would not say all of these would be realized in the first half. And again, I would not equate what will be realized losses with the reserve. I think the reserve kind of plays a different analysis unless, again, it's a very near-term resolution where, for example, an asset's already under contract for a specific price. Then obviously, those two numbers come together.

But for longer-term resolutions assets, there can be variance between what the actual realized value is or the losses versus the CECL reserve.

Bryan Donohoe (CEO)

Yeah. And I'll just add to that. I think that the leverage ratio that Tae-Sik touched on earlier gives us that flexibility. So I certainly hear your point, and I think velocity is something it's certainly part of the equation, but we're balancing that with ultimate resolution. We absolutely look forward to getting back on offense when available, and I think the resolution of some of these assets will be indicative of that. But I think ultimate resolution is a balance of price plus timeline.

Rick Shane (Managing Director)

I think we see the logic here in terms of where the dividend has been struck. If we think about where book value is today and looking at book excluding reserves because I think realistically, that will be reasonably close to the amount of book value you have on a go-forward basis. The dividend equates to a return of just over 8.5%. I think that's pretty consistent with mid-cycle returns for your company on a scale basis over the long term. Is that the right way to be thinking of these things?

Tae-Sik Yoon (CFO)

Yeah. It's an excellent observation. I certainly think that is one way to, I would say, triangulate to sort of a yield that makes sense. Again, I would just caution, however, that we are in, as I mentioned, very dynamic market times. For example, in one sense, we're enjoying very high interest rates with SOFR being at the 5.3-5.4 level. On the other hand, 5.3-5.4 SOFR is causing significant and adverse impact on real estate operating performance and values. And so there's a lot of components that go into our overall returns. So certainly credits, certainly interest rates, certainly leverage, certainly deployment. There's a lot of factors that go into it.

But I do agree with your observation that the $0.25 dividend for the fourth quarter—I'm sorry, for the first quarter of 2024—if you were to annualize that to $1, $1 being divided by the $11.50 book value, equates to that, I think, about an 8.7% yield. I do think that's a great way to triangulate maybe the sensibility of it. But I would also caution that the story isn't fully told yet, right? As we mentioned, we have set our dividend level based upon what we believe we can earn by resolving some of the non-accrual loans, not all of the non-accrual loans. So we do have potential for adding in more earnings at the same time without going through the full list. I mean, there are lots of other factors that can and are likely to impact our earnings going forward as well.

That is part of the equation, but certainly not the only part of the equation.

Rick Shane (Managing Director)

Got it. Look, it's an interesting observation that you make. And in terms of sort of the long term, I would agree with you on average over time, but that's probably six years out of 10 in that eight range, two years out of 10 above it, and two years out of 10 below. And we're probably in the midst of or in the thick of those two or three years that are below that 8.5% target.

Tae-Sik Yoon (CFO)

Yes.

Rick Shane (Managing Director)

Thank you, guys.

Bryan Donohoe (CEO)

Thank you.

Operator (participant)

We'll take our next question from Don Fandetti of Wells Fargo. Your line is open.

Don Fandetti (Managing Director)

Tae-Sik, I guess I'm trying to just get a sense of your confidence as you think about the shorter term. How are you feeling about the ability for just a replay of this in Q1 where you have kind of non-accrual migration and other big reserve build? I know there's uncertainty kind of intermediate, longer term. How are you thinking about it in the short term?

Tae-Sik Yoon (CFO)

Sure. Again, our short-term objective is part of a longer-term plan, of course. But our short-term objective, as we mentioned, is to remain very, very focused on the non-performing loans. It's to remain very, very focused on continuing to vigilantly monitor all of our loans overall. We are in a state as of the fourth quarter, as of year-end, where we have a significant portion of our capital in non-accrual loans. And so that is clearly the impact of our current income. Having said that, as we've mentioned, a number of our loans, even though they're on non-accrual, continue to pay interest. And that interest is not being recognized as income. That interest is being used to reduce the carrying value of the loan itself. So we think all of that helps to further improve the balance sheet overall.

But again, to answer your question, short term, we remain very focused on growing our income base and our overall distributable earnings. We want to continue to vigilantly work out any of the problem assets so that we can either monetize the capital that we have in the asset, we can pay down the debt associated with those assets, the liabilities associated with the non-performing loans, and then redeploy some capital. We have a significant amount of liquidity. We will hopefully generate more capital from the resolution of some of these loans. One of the things we mentioned is we are working very closely with many of our borrowers to continue to inject more equity into the loans themselves. But short term, I would tell you also that we continue to see some volatility in the markets and in our portfolio.

I think one of the subsequent events that we had mentioned in our public filings this morning is that we had two loans go into default at year-end, after year-end. One loan was a $57 million loan backed by an office property that matured. Obviously, that loan has been rated to five. That's the loan that Bryan had mentioned. We were pushing to sell before year-end. We continue to push to sell that loan. So the resolution of that loan will be a material part of this plan going forward. The other loan that we mentioned is the $18.5 million New Jersey loan. That loan also went into default as a result of the borrower not making its January interest payment. Unfortunately, that loan remains in default, and the January and now February payment has not been made.

That loan, as we mentioned, has been on non-accrual for the past couple of quarters. That loan going into default, while it's very disappointing, obviously, has already been on non-accrual, has been rated a four. There continues to be movement in the portfolio.

Don Fandetti (Managing Director)

Okay. Got it. Thank you.

Operator (participant)

We'll take our next question from Steve Delaney of Citizens JMP. Your line is open.

Steve Delaney (Managing Director)

Thank you. Good morning, Bryan and Tae-Sik. We're starting to see something interesting this quarter and hearing anecdotes that there are a number of debt funds or even hedge funds that are starting to look around for opportunities to kind of opportunistically buy loans from. I'm sure they're talking to the banks, but we've seen evidence that they've been talking to the commercial mortgage REITs as well. I'm curious if you're receiving any. If you can just say generally, are you receiving these types of inquiries by third parties looking to kind of step in so that you can avoid foreclosure and all that mess and actually just lay off the loan to somebody who works more not in a public company environment and can operate a little differently? Just curious if you're seeing this secondary market in distressed loans picking up at all.

Bryan Donohoe (CEO)

Yeah. It's a great question, Steve. I think the loan held for sale at year-end was a good example of executing on just that strategy. I think there's two major narratives in commercial real estate, well, probably more, but one of which is this wall of maturities, and the other is this wall of capital. And I think certainly touched on a little bit of the macro environment shifting. And part of that is that the capital on the offensive side being dislodged and becoming more pro-business, I would say. So I think that you're seeing a good reflection throughout the space of deal activity. And in general, the first market opportunity in commercial real estate will come in the form of credit, whether that's in new loans that are attracted on a relative value basis or purchasing loans either for control or for yield.

So I think you're spot on. The activity is here, and I think it will continue to progress. But the amount of capital that's out there that needs to be spent in the space is significant. So the trend that you've seen or you're hearing about, I would expect it to continue.

Steve Delaney (Managing Director)

I appreciate that. And I would have to think the Fed is kind of giving us a headfake here, but I'd have to think if we start getting into the middle of this year and there is more of an expectation for cuts in the second half of the year, that that may make those potential buyers more aggressive because you're creating a more positive sentiment for the market generally, and people are going to be less willing to sell at large discounts. So I could see this interest of this opportunistic money really picking up as the year goes along. And then the second thought I have is I've been hearing this about the banks.

We all know what the capital issues are with the banks, but that we're hearing that construction loans at the banks, that the banks are going to manage through those but probably will be less likely to move into a bridge lending phase, and that that would be maybe when we get to late 2024, early 2025, we could find a new wave of lending opportunities for the commercial mortgage REITs with paper coming off the bank's balance sheet. Do you see that type of opportunity as well, or am I getting ahead of myself there?

Bryan Donohoe (CEO)

Okay. I think if you think about the concentration of commercial real estate debt within the banks and certainly when you dig through the real estate capital treatment for the bank's balance sheet of CRE and if you overlay that regulator or Fed focus on the banking sector, it doesn't take a large shift of the allocation of real estate debt from banks going into the private markets to create a pretty substantial opportunity set to invest into. So that's certainly what I think Ares and our peers said is playing for, is that continued shift. I think it's going to be a great opportunity to partner with the banks in this next evolution of the real estate debt market. So I would certainly look forward to that. I think I'd echo your sentiment, though.

Steve Delaney (Managing Director)

Wow. Congratulations on the progress you're making. I know it's a slog, but I think we have better days ahead for ACRE and for the group as a whole. So thank you for your time this morning.

Bryan Donohoe (CEO)

Appreciate it, as always, Steve. Thank you.

Operator (participant)

We'll take our next question from Doug Harter of UBS.

Doug Harter (Equity Research Analyst)

Thanks. I was just hoping you'd give a little more update on the multifamily portfolio and kind of how, given the move-in rates, how you think that that portfolio is going to be able to handle refinancing?

Tae-Sik Yoon (CFO)

Yeah, absolutely. I think one of the benefits of the multifamily market is the continued capital markets participation of Fannie and Freddie, as well as it being a more friendly bank asset as well. I'd say that we've seen supply uptick nationally. I think mark-to-market, that's being received differently. Largely speaking, within our portfolio, we've seen positive progress on the leasing side. So I think it will be an opportunity set for the foreseeable future. I think when we think about it structurally, you're still going to be short despite the supply headwinds that have been fairly well publicized. We're still going to be short over the next five years, four or five, six million residences in the United States, especially if you look at a macro level of immigration returning, right?

So in terms of liquidity, the buyers, the owners of multifamily real estate assets are seeing that the short-term supply issues are dwarfed by the long-term fundamental shortage, and you're starting to see the performance of the underlying assets reflect that. So short answer is relatively stable performance within our portfolio. I think that the capital markets functionality will continue to support these assets, and the private equity markets for multifamily will continue to expand.

Steve Delaney (Managing Director)

Great. Thank you.

Operator (participant)

Once again, if you would like to ask a question, that is star one on your telephone keypad. We'll move next to Jade Rahmani of KBW.

Jade Rahmani (Managing Director)

Thank you very much. Just to follow up on your answer to Doug's question, Green Street estimates multifamily values are down around 28% from the peak. I mean, when we hear answers like that, it's as if that's a non-event. So either we disagree with Green Street or we need to recognize that there's capital stress in a lot of the multifamily deals that was record issuance in 2021 and 2022. So just to ask it another way, how do you expect this to be reconciled over the next year in multifamily? Secondly, I would like to ask about two multifamilies in which Ares was involved. I think that they are likely in the ACRE portfolio, but wanted to check. One was a large Chicago multifamily, and another is in Dallas. And those look like, based on The Real Deal, there are performance issues there.

Tae-Sik Yoon (CFO)

Yeah, Jade, I guess I don't want to misrepresent. I think that if you go back to certain markets and you were in the spring of 2022 purchasing at, I'd say, trough cap rates, there's probably value decline in excess of the 28% you're citing through Green Street. In many instances, we've seen rent growth, and I think those buyers saw the perceived rent growth in certain markets continuing unabated with expenses that didn't necessarily go in tow with that. But largely speaking, as a lender, even if you subscribe to the Green Street number, moderate leverage, there's still equity to protect in those assets. I think you will see some transfer of value from equity to debt. So it's not that there won't be distress.

I just think that when you consider overall loss severity in the space to the lender community, I think that will be muted relative to if you look at the office sector, for instance. So it's not to say that there won't be transfers of assets given that value decline. And certainly, if you got the vintage wrong, if you got the expense load wrong, there will be distress. And I think the two assets you were talking about reside in different vehicles. The press doesn't always get the lender correct there. So Ares is associated with those assets, but they are not ACRE assets specifically.

Jade Rahmani (Managing Director)

Thanks. Appreciate that. So in terms of the transfer of assets within a portfolio such as a mortgage REIT portfolio, if you don't expect ultimately significant loss severity to the lenders, how do you expect this to play out? Do you see the mortgage REITs being active in bringing in additional capital to recapitalize transactions?

Tae-Sik Yoon (CFO)

I think that's certainly a possibility. But I think despite the technology overlay we've seen in the multifamily sector, specific asset management capabilities within the borrower community have never been more important. When you think about some of the issues around fraud and otherwise in the apartment sector, how you manage these assets is a good bit of a value creation. And I do think, to your point, Jade, there's ample liquidity to come in on the private side alongside existing lenders recapitalizing an asset and bringing to bear improved asset management or property management from there. So I think you're spot on that this might take the form of partnership rather than outright sales to kind of stabilize the valuations.

I think, to the earlier point on the decline in rates or even the stability around rates, multifamily over the next five years will be fairly well correlated to the rate environment.

Jade Rahmani (Managing Director)

Thank you. And then lastly, if I could squeeze one more in, there was an industrial property I can't recall offhand if you've previously discussed this, but it was moved to non-accrual status. It's relatively small compared to the average at $19 million, but we haven't seen much pressure there. So could you comment on that situation?

Bryan Donohoe (CEO)

Yeah. This is a redeveloped asset on the West Coast. I think we've basically, in the analysis of that property, the dialogue with the borrower is dynamic, and it is a relatively small asset, however. So asset discussions with that borrower with a rate cap coming up is really the catalyst for the analysis.

Jade Rahmani (Managing Director)

The non-accrual was due to the rate cap, not leasing outlook or supply competition or anything of that nature?

Bryan Donohoe (CEO)

I think it was slower than expected leasing velocity alongside a near-term event of the rate cap.

Jade Rahmani (Managing Director)

Okay. Thanks a lot.

Bryan Donohoe (CEO)

Thanks, Jade.

Operator (participant)

There are no further questions at this time. I'd be happy to return the call to Bryan Donohoe for closing comments.

Bryan Donohoe (CEO)

Yeah. Thank you, operator. I just want to thank everybody for the time today. We appreciate the continued support of Ares Commercial Real Estate, and we look forward to speaking to you again on our next earnings call. Thank you.

Operator (participant)

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's call, an archived replay of this conference call will be available approximately one hour after the end of this call through March 21st, 2024 to domestic callers by dialing 1-800-723-0544 and to international callers by dialing area code 402-220-2656.

An archived replay will also be available on a webcast link located on the homepage of the investor resources section of our website.