Ares Commercial Real Estate Corporation (New York stock market :ACRE), a real estate investment trust (“REIT”), offers investors an 11% dividend yield that is fully covered by the trust’s distributable earnings, rising income from rising interest rates and a strong portfolio of high-quality Senior Loans.

This package can also be purchased currently at a significant discount to Ares Commercial Real Estate book value. I think the trust’s 11% dividend yield is sustainable and the valuation maintains a high margin of safety.

Senior Loan Focus Loan Portfolio and Interest Rate Exposure

As of September 30, 2022, Ares Commercial Real Estate‘s portfolio was valued at $2.5 billion and consisted of 98% high quality senior secured loans.

The trust closed $50 million in new loan commitments and received $167 million in loan repayments in the third quarter, resulting in a decline in portfolio value of approximately $100 million quarter-over-quarter.

In the third quarter, Ares Commercial Real Estate maintained a strong focus on the office and multifamily sectors, which accounted for 54% of Ares Commercial Real Estate’s loans.

Ares Commercial Real Estate is benefiting from the Federal Reserve’s aggressive rate hike cycle. The central bank raised interest rates by 75 basis points earlier this month, marking the fourth straight increase of 75 basis points in 2022.

Since 98% of Ares Commercial Real Estate loans are variable rate, higher interest rates lead to increased loan portfolio income.

According to Ares Commercial Real Estate’s most recent interest rate sensitivity table, a 100 basis point increase in interest rates would result in a $0.20 per share increase in distributable earnings.

Base dividend and additional dividends remained covered by distributable earnings in 3Q-22

In the third quarter, Ares Commercial Real Estate covered its dividend with distributable income. The trust earned $0.39 per share on its loan portfolio and paid $0.33 in regular dividends and $0.02 in additional dividends to shareholders, for a total payout ratio of 90%.

Ares Commercial Real Estate’s payout ratio was 92% over the past year, indicating that the trust’s dividend has always been covered by earnings. ACRE’s payout ratio includes the additional dividend of $0.02 per trust share, which has been paid consistently over the past four quarters.

Ares Commercial Real Estate covered its dividend with distributable profits over a longer period. Since 2018, the trust’s dividend has consistently far outperformed its dividend payout, with ACRE’s dividend coverage ratios ranging from 1.0x to 1.2x.

Earn 11% return for a 16% book value discount

The Ares Commercial Real Estate dividend has a high margin of safety, due to its availability at a discount to book value. The book value of the trust at the end of September was $14.09, representing a discount of 16%.

Given that Ares Commercial Real Estate’s investment portfolio is largely comprised of high quality senior loans with very low loss rates, I believe investors are making a serious mistake in pricing the shares of the trust at such a high discount.

Why ACRE might see a lower/higher rating

Mortgage originations will continue to be critical to the Trust’s performance in terms of distributable earnings going forward, and there are currently no signs of distress in the commercial real estate market.

That said, a major downturn in the US housing market could alter the investment landscape and lead to lower distributable earnings and dividend coverage.

Investors can mitigate this risk by investing a small portion of their funds (say, no more than 5% of their portfolios) in stocks such as ACRE.

My conclusion

Ares Commercial Real Estate is a well-managed real estate investment trust whose shares trade at a 16% discount to book value and easily covered its dividend with distributable profits in the third quarter.

The trust prioritizes security by relying on a highly secured investment portfolio based on senior loans, and it has significant portfolio income as the majority of its loans (98%) are variable rate.

I think Ares Commercial Real Estate Corporation is worth a higher valuation multiple, and the 11% dividend yield should be relatively safe going forward.