Executive Summary / Key Takeaways

• Ares Commercial Real Estate (ACRE) has successfully executed a strategic pivot over the past year, significantly strengthening its balance sheet by boosting liquidity and reducing leverage to address higher-risk assets.
• First Quarter 2025 results reflect this transition, showing decreased net interest margin due to a smaller portfolio and lower SOFR, but no new realized loan losses and a net reversal of credit loss reserves, indicating some stabilization in credit outlook.
• Key balance sheet improvements include a substantial reduction in outstanding borrowings, a lower net debt-to-equity ratio (1.2x), and increased available capital ($147 million as of May 2, 2025), providing crucial flexibility for asset resolutions.
• The company's immediate focus remains on accelerating the resolution of risk-rated four and five loans and reducing office exposure, with the strategic goal of demonstrating the underlying book value.
• While near-term earnings may remain uneven during this resolution phase, the strengthened balance sheet and the capabilities of the broader Ares platform position ACRE to opportunistically return to new investments and portfolio growth in a more stable market environment, potentially in the second half of 2025.

Setting the Scene: ACRE's Position in the CRE Debt Landscape

Ares Commercial Real Estate Corporation operates as a specialty finance company primarily focused on directly originating and investing in commercial real estate (CRE) debt. Structured as a real estate investment trust (REIT) since 2012 and externally managed by Ares Commercial Real Estate Management, LLC, a subsidiary of global alternative investment manager Ares Management Corporation (ARES), ACRE leverages the broader Ares platform's extensive network and expertise. The company's target investments span the CRE debt spectrum, including senior mortgage loans, subordinated debt, preferred equity, and mezzanine loans, generally secured by a diverse range of property types across the United States.

The CRE debt market is a competitive arena, with ACRE vying for opportunities against a varied set of players. Direct competitors include other publicly traded CRE credit REITs such as BrightSpire Capital (BRSP), Starwood Property Trust (STWD), and Blackstone Mortgage Trust (BXMT). These firms often overlap in originating and investing in similar types of CRE loans. Indirect competition comes from traditional banks, private equity firms, and increasingly, financial technology (fintech) platforms offering alternative financing solutions.

ACRE's competitive positioning is significantly shaped by its affiliation with Ares Management. The company benefits from access to Ares' deep industry relationships, proprietary deal sourcing channels, and extensive real estate investment and asset management expertise. This platform provides a crucial differentiator, aiding in disciplined underwriting, risk assessment, and active portfolio management. While specific quantifiable metrics comparing the platform's efficiency or technological edge against all competitors are not publicly detailed, the strategic intent is clear: to leverage this integrated capability for potentially faster deal processing and superior risk-adjusted returns compared to peers who may lack such a broad, vertically integrated real estate operation. The recent acquisition of GCP by Ares, which more than doubled the size of the Ares Real Estate team and expanded expertise into areas like logistics, data centers, and self-storage, further enhances this platform, promising added scale and specialized knowledge that can be brought to bear on ACRE's portfolio and future opportunities.

However, ACRE also faces competitive challenges. Its external management structure, while providing access to the Ares platform, can result in higher operating costs compared to internally managed peers like BRSP. Furthermore, ACRE's scale, while substantial, is smaller than that of giants like STWD or BXMT, potentially limiting its participation in the largest transactions and impacting its ability to achieve the same level of cost efficiency through scale.

A Strategic Pivot in Challenging Markets

ACRE's history since its 2012 IPO has seen it grow into a significant player in the CRE debt space. However, starting approximately two years ago, coinciding with the Federal Reserve's aggressive interest rate hiking cycle and subsequent distress in the CRE market, the company initiated a strategic pivot. Recognizing the increased uncertainty and potential for underperformance in certain asset classes, particularly office properties, ACRE set two primary goals: first, to enhance balance sheet flexibility and liquidity, and second, to prudently resolve higher-risk assets and prepare to reinvest capital into more stable opportunities.

This strategy has been the driving force behind ACRE's actions over the past year and into early 2025. The focus shifted from portfolio growth to de-risking and fortifying the financial position. This involved actively working to resolve challenged loans, managing real estate owned (REO) properties acquired through foreclosure, and strategically managing the company's financing structures.

Performance Reflecting Transition and De-Risking

The financial results for the three months ended March 31, 2025, clearly reflect this period of strategic transition and de-risking. Total revenue decreased to $14.9 million from $18.7 million in the prior year period. This decline was primarily driven by a lower net interest margin, which fell to $9.3 million from $15.2 million. The decrease in net interest margin was a direct consequence of a smaller weighted average earning asset base and reduced weighted average borrowings, coupled with a decrease in SOFR rates compared to the prior year. This illustrates the near-term impact on earnings from the strategic decision to reduce leverage and portfolio size to enhance flexibility.

Revenue from real estate owned, however, increased to $5.7 million in Q1 2025 from $3.5 million in Q1 2024. This increase is attributable to the acquisition of an office property in North Carolina in September 2024 through a deed in lieu of foreclosure, adding to the revenue generated by the mixed-use property in Florida acquired in September 2023 via foreclosure. Expenses from these REO properties also increased commensurately, rising to $4.5 million from $2.0 million.

Operating expenses saw some shifts. Management fees decreased slightly to $2.6 million from $2.8 million, primarily reflecting a lower weighted average stockholders' equity. General and administrative expenses also decreased, largely due to reduced stock-based compensation expense. Conversely, professional fees increased to $0.9 million from $0.5 million, reflecting increased use of third-party professionals, likely related to asset resolution activities.

A notable positive in the first quarter of 2025 was the provision for reversal of current expected credit losses, net, which stood at $5.3 million. This compares to a much larger reversal of $22.3 million in Q1 2024. The Q1 2025 reversal was primarily driven by improvements in near-term macroeconomic forecasts, a shorter average remaining loan term, and the impact of loan repayments. While the prior year's larger reversal was influenced by specific realized losses and associated reserve reversals, the Q1 2025 figure suggests a more stable credit outlook on the remaining portfolio compared to the significant adjustments made in the prior year. Crucially, ACRE reported no realized losses on loans in the first quarter of 2025, a significant improvement compared to the $45.7 million in realized losses incurred in Q1 2024. The company also collected $2.9 million in cash interest on non-accrual loans, which was applied to reduce the loan basis rather than recognized as income.

As of March 31, 2025, the total loans held for investment portfolio had a carrying value of $1.36 billion and an outstanding principal balance of $1.40 billion, down from $1.66 billion and $1.70 billion, respectively, at December 31, 2024. This reduction reflects the strategic focus on shrinking the portfolio through resolutions and limited new originations. The portfolio consisted of 27 loans, primarily senior mortgage loans ($1.34 billion carrying value). As of the same date, 68.3% of loans had SOFR floors with a weighted average floor of 0.96%.

The credit quality of the portfolio remains a key focus. As of March 31, 2025, ACRE had five loans on non-accrual status with a carrying value of $321.5 million. The risk rating distribution showed one loan rated 5 (Impaired/Loss Likely) and four loans rated 4 (High Risk/Potential for Loss). The total CECL reserve for loans held for investment was $139.6 million (945 basis points of total commitment), including a $131.4 million contra-asset reserve and an $8.2 million liability for unfunded commitments. The risk-rated 5 Illinois office loan ($165.1 million principal) had a specific CECL reserve of $57.7 million. Management believes they are properly reserved for the risk-rated four and five loans.

Fortifying the Balance Sheet

A core component of ACRE's strategy has been to build a more resilient balance sheet. This effort yielded significant results in the first quarter of 2025. The company collected $307 million in loan repayments, representing the highest amount as a percentage of outstanding principal balance in its history and more than double the repayments received in the prior quarter. These repayments, coupled with strategic financing actions, allowed ACRE to reduce its outstanding borrowings by $228 million, bringing the total to $946 million.

This translated into a sharp decline in the net debt-to-equity ratio (excluding CECL) to 1.2 times at the end of Q1 2025, down from 1.6 times in Q4 2024 and 1.9 times in Q1 2024.

Strategic financing initiatives further bolstered the balance sheet. In March 2025, ACRE redeemed its FL3 CLO securitization, replacing it with more efficient financing under existing secured funding facilities. This move lowered borrowing costs by 86 basis points at the outset and secured a higher advance rate on the underlying assets. The company also extended the maturity of key facilities, pushing the Wells Fargo (WFC) Facility's initial maturity to February 2028 (with extension options to 2030) and the CNB Facility's (CYN) maturity to March 2026.

These actions culminated in a significant increase in available capital, reaching $147 million as of May 2, 2025, including $113 million in cash. This represents a 15% increase since the end of 2024 and provides ACRE with substantial flexibility.

Outlook and Capital Allocation

With a significantly strengthened balance sheet, ACRE is now positioned to accelerate its strategic objectives. The primary focus for 2025 remains on resolving the remaining risk-rated four and five loans and reducing office concentration. Management is intently focused on driving positive outcomes for these assets, including the largest risk-rated 5 Chicago office loan (seeing positive leasing momentum) and the risk-rated 4 Brooklyn residential condo loan (progressing towards sales in late 2025/2026). The goal is to bring further certainty to the portfolio and demonstrate the company's book value, which currently includes a $140 million CECL reserve but trades at a significant discount, implying an additional $300 million discount according to management.

The increased liquidity provides ACRE with optionality for capital allocation. This includes the potential to selectively originate new loans, opportunistically repurchase common shares under the existing $50 million authorization (which expires July 31, 2025, and saw no activity in Q1 2025), further repay debt, or fund other strategic initiatives. While management acknowledges that maintaining higher liquidity impacts near-term earnings, they view this as a necessary trade-off to maximize resolution outcomes. Near-term earnings are expected to remain uneven as the company works through this phase.

Looking ahead, the company expects its primary sources of cash to be sufficient for its needs for at least the next 12 months and beyond. Management indicated that a return to a more active stance on new loan originations and portfolio growth is contingent on successfully resolving the remaining problem assets and market conditions stabilizing further, potentially in the second half of 2025. The activity seen on the broader Ares platform in originating loans ($3B+ through Q3 2024) signals that market opportunities exist when ACRE is ready to participate. The Board declared a regular cash dividend of $0.15 per common share for the second quarter of 2025, reflecting their ongoing evaluation of returns in the context of the current strategic phase and market environment.

Risks and Challenges

Despite the progress made, ACRE faces ongoing risks. Credit risk remains pertinent, particularly within the risk-rated four and five loans and office exposure, where borrower distress or unfavorable market conditions could lead to further losses. The CECL reserve reflects management's estimate of expected losses, but actual outcomes could differ. Interest rate risk, while partially mitigated by the floating-rate nature of assets and liabilities and SOFR floors, could still impact net interest margin if rates move unexpectedly or if non-performing assets are sensitive to higher debt service costs. Prepayment risk could affect yields if performing loans repay faster than anticipated, while slower prepayments or extensions could strain financing terms. Financing risk includes the potential for margin calls, covenant breaches, or challenges in refinancing facilities, although recent extensions have provided runway. Real estate risk, particularly in challenged sectors like office and life sciences, could impact collateral values and borrower capacity to repay. Inflation risk could also erode returns if not offset by interest income.

Management actively monitors these risks through due diligence, portfolio review, and dialogue with borrowers and lenders. The strategic focus on increasing liquidity and reducing leverage is a direct response to enhance the company's ability to withstand potential negative impacts from these risks during this uncertain period.

Conclusion

Ares Commercial Real Estate has embarked on a deliberate and impactful strategic transformation, prioritizing balance sheet strength and the resolution of underperforming assets over near-term portfolio growth. The first quarter of 2025 demonstrates significant progress in this endeavor, marked by substantial debt reduction, increased liquidity, and strategic financing enhancements. While this phase has led to a smaller portfolio and uneven earnings, it is a necessary step towards addressing credit risks and bringing clarity to the company's book value.

The core investment thesis for ACRE in the current environment centers on the potential for value realization as the company successfully works through its remaining challenged assets. The ample liquidity and lower leverage provide the necessary flexibility to navigate these resolutions effectively. Supported by the robust platform and expanding expertise of Ares Management, ACRE is positioning itself to eventually pivot back to opportunistic new investments and portfolio growth. Investors should monitor the pace and outcomes of the risk-rated four and five loan resolutions and the company's capital allocation decisions as key indicators of progress towards demonstrating book value and returning to a higher level of sustainable profitability.