Ares Commercial: A 12.5% Yield On My Last Purchase (NYSE:ACRE)

I received a dividend yield of 12.5% on my most recent purchase of Ares Commercial Real Estate Corporation (NYSE:ACRE), and I recommend the stock to passive income investors.

Despite the fact that ACRE’s dividend yield has fallen to 12.2% at the time of writing, I believe Ares Commercial Real Estate provides passive income investors with a sustainable dividend as well as a high margin of safety at the current valuation level.

The commercial trust has a portfolio of high-quality mortgage loans as well as potential net interest income growth from the current rate-hiking cycle.

Furthermore, the selloff has increased the trust’s book value discount to 23%, which I believe provides investors with an overly generous margin of safety.

Selloff Represents Doubling-Down Opportunity

The December selloff created an opportunity to double down on well-managed real estate investment trusts such as Ares Commercial Real Estate, which owns a large portfolio of commercial real estate debt-related investments.

Ares Commercial Real Estate’s investment portfolio contained 70 loans as of September 30, 2022, with 98% of them being highly secured senior loans.

These loans are secured by real estate, specifically office and multi-family properties. Ares Commercial Real Estate maintains these loans on its balance sheet and earns interest income on them.

The trust’s net interest margin (the difference between interest income on loan assets and expenses incurred by financial liabilities) was $27.2 million in 3Q-22, up 27.7% YoY. The trust’s exposure to floating-rate interest rates is the driving force behind ACRE’s net interest margin expansion.

Well-Positioned For Higher Interest Rates

Ares Commercial Real Estate is well positioned to benefit from an increase in the benchmark federal funds rate, which the Fed began raising in 1Q-22 to combat inflation.

As the central bank continues to raise interest rates, the real estate investment trust has proactively positioned its loan portfolio toward floating rate senior loans, which will earn the trust higher net interest margins.

The market consensus is that interest rates will be raised again in 2023 as the central bank pursues its policy goal of containing inflation. A 100-basis-point increase in the federal funds rate could increase Ares Commercial Real Estate’s net earnings by $0.20 per share per year.

ACRE Offers A Very Attractive Dividend Yield

Ares Commercial Real Estate pays a $0.33 per share per quarter dividend that has been covered by distributable earnings over the last year.

Ares Commercial Real Estate had a dividend pay-out ratio of 92% over the last twelve months, and the company was even able to distribute excess income in the form of supplemental dividends.

In a rising-rate environment, higher net interest income from the trust’s loan portfolio could improve Ares Commercial Real Estate’s dividend coverage.

ACRE stock pays a dividend yield of 12.2% at the current price of $10.85. If the trust continues to pay a supplemental dividend of $0.02 per share over the next four quarters, the actual dividend yield could rise to 12.9%.

Discount To Book Value Has Widened To 23%

Ares Commercial Real Estate is currently trading at a P/B ratio of 0.77x, implying a 23% book value discount. The discount exists despite the trust’s dividend being paid out of distributable income, having a diverse, senior-focused loan portfolio, and having net interest income upside from a rise in the benchmark federal funds rate.

I believe the December increase in the BV discount was unjustified, and the valuation reflects an even greater margin of safety for passive income investors.

Why Ares Commercial Could See An Even Higher BV Discount

The origination volume of Ares Commercial Real Estate is determined by the state of the commercial real estate market. If demand for originations/capital falls and the commercial segment of the U.S. real estate market enters a slump, the trust may face slower distributable earnings growth in the future.

Ares Commercial Real Estate may also be unable to reap the benefits of its floating rate portfolio if the central bank reverses course after bringing inflation under control in 2023.

My Conclusion

Ares Commercial Real Estate is a very appealing trust to consider on the drop because the dividend yield has increased to about 12.2% while the discount to book value has increased to 23%.

The trust’s dividend is being covered by distributable earnings, and exposure to floating rate loans may result in an improved dividend pay-out ratio and even a higher dividend.

The discount to book value represents a very high margin of safety, allowing passive income investors to sleep soundly without worrying about the trust’s dividend.