Ares Commercial Real Estate Corp (ACRE) 2015 Q2 法說會逐字稿

Good afternoon and welcome to Ares Commercial Real Estate Corporation's conference call to discuss the Company's second quarter 2015 earnings results. As a reminder this conference call is being recorded on July 30th, 2015. I would now turn the conference call over to Mr. John Stilmar from Ares' Investor Relations.

Good afternoon and thank you for joining us on Ares' second quarter 2015 Earnings Conference Call. On today's calling we have Todd Schuster, Ares' President app CEO; and Tae-Sik Yoon Ares' Chief Financial Officer. In addition to our press release and 10-Q that we filed with the SEC we have posted an Earnings Presentation under the investor resources section of our website at ww.arescre.com.

Before we begin I want to remind everyone that comments made during the course of this conference call and webcast and the accompanying documents contain forward-looking statements and are subject to risks and uncertainties. Many of these forward-looking statements can be identified by the 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, conditions 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 filings. Ares Commercial Real Estate assumes no obligation to update such forward-looking statements. Please also note that past performance or market information is not a guarantee of future results.

I will now turn the call over to Todd Schuster, Ares' President and CEO. Todd?

Thanks, John. I am very pleased to report a strong second quarter for Ares in which our business generated net income of $9 million or $0.31 per share representing a 35% year-over-year increase. These results were driven by combining strong recurring earnings from our principal lending business and improving earnings growth at Ares Capital our market banking business. Based upon the broad-based strength of our business and our favorable outlook, we are increasing our 2015 annual earnings guidance from a range of $1.04 to $1.14 per share to a range of $1.12 to $1.18 per share. Importantly much like 2014 set the stage for earnings growth in 2015 we believe that our actions in 2015 are positioning us for a continuation of the same in 2016 and beyond.

I want to take a couple of minutes to highlight some of our more specific accomplishments in the second quarter. Starting with our principal lending business we earned $6.8 million compared to $5.6 million in the second quarter of 2014 representing year-over-year growth of 21%. More over, we continue to find investment opportunities to further expand ROEs. For example, during the second quarter we closed a $39 million senior loan collateralized by a nationally flagged full-service hotel located in suburban New York. We expect this investment to be highly accretive with mid-teens returns before expenses. Furthermore, during the quarter we continued to execute on our goal of growing earnings with our existing capital base. Just a few weeks ago we completed the sale of one of our lowest yielding loans, a $75 million first mortgage collateralized by an office park in Southern California. We believe the sale of this loan at par and the subsequent reinvestment of the repatriated capital into new assets and the repurchase of our stock can generate 200 to 400 basis points of incrementally higher ROEs. More over, our historical based accounting does not reflect the value of our assets particularly as spreads have tightened over the past few years. We believe that a sale of one of our lowest yielding assets at the 100% of par further substantiates this view and highlights the opportunity we see in our stock given the discount to book valuation.

Turning to our market banking business we earned $2.2 million in the quarter reflecting a more favorable mix of higher margin products and a 15% increase in volume both relative to the prior quarter. While margins may fluctuate from quarter to quarter we expect margins in the second half to be similar to the second quarter as opposed to the lower margins experienced in the first quarter.

Lastly, I want to address our share repurchase program that we announced in May. We believe that our stock is trading well below its intrinsic value and at today's levels we believe that stock repurchases could be an accretive way to build book value and earnings. I will now turn the call over to Tae-Sik.

Great. Thank you, Todd and good afternoon everybody. I am going to begin today with a recap of our second quarter results and summarize our loan portfolio and our liquidity and then conclude with an update to our full year 2015 earnings guidance. We are very pleased to announce that our second quarter 2015 results was $9 million or $0.31 per diluted common share compared to $6.6 million or $0.23 per diluted common share for the same period a year-ago. This represents a 35% increase in our earnings-per-share year-over-year.

At quarter-end we had 41 loans held for investment totaling $1.4 billion in commitments and $1.2 billion of outstanding principal excluding non-controlling interest held by third parties. All of our loans held for investment continue to perform in accordance with their terms and we have no delinquencies, defaults or impairments as of June 30, 2015. We also continue to match fund our assets and liability with respect to interest rates. Approximately 90% of our $1.2 billion in loans held for investment as measured by outstanding principle are floating rate meaning that they earned interest based on one month LIBOR. This compares well to our liability structure where approximately 93% is also comprised of floating rate debt. Due to our match funding strategy we believe that we are well-positioned to benefit in a rising interest rate retirement so that as LIBOR goes up we expect our net income to go up as well.

Turning now to our mortgage banking segment, we originated $233 million in new loans comprised of $90 million in Fannie Mae DUS loans, $100 million in Freddie Mac loans and $43 million of FHA production. As far as liquidity as of July 29, 2015, we have approximately $63 million of cash or approved in undrawn capacity under our financing facilities. After reserving approximately $10 million for liquidity this leaves us with approximately $53 million of investable capital which together with leverage gives us capacity to originate approximately $150 million to $200 million of additional senior loans assuming a two to one to three to one debt-to-equity ratio.

Now, let me address our $69 million convertible notes which are coming due in December. We continue to pursue a numbers of opportunities to refinance this debt and, in fact, we believe that it represents an opportunity to further reduce our cost of capital as the current all in cost in convertible notes are approximately 9.4%. That being said, as market conditions should adversely change our current liquidity and a modest amount of repayments provides us ample visibility to the liquidity needed to retire the $69 million of convertible notes. Bottom line we continue to feel very good about our repayment of the upcoming convertible notes.

Looking out into the remainder of 2015. As Todd mentioned, we have increased our earnings guidance for the full year to $1.12 to $1.18 in diluted common share from our earlier levels of $1.04 to $1.14. That represents an $0.08 increase in the bottom end and a $0.04 increase on the upper end. This increase in our guidance range reflects our continued execution against our goals as well as our continued confidence in our business plan for the second half of this year.

I mentioned earlier that we have had no delinquency, defaults or impairments in our principal lending portfolio since our IPO more than three years ago. We believe that we have managed our credit exposure well and we continue to feel very good about our loan portfolio including our exposure to the energy markets. For example, as we have stated previously, our exposure to the Houston, Texas market is limited. In our principal lending portfolio we have loans only on existing apartments totaling $77 million in outstanding principal in the Houston market. These loans are continuing to perform well and are operating in accordance with their underwritten business plans. Similarly in our mortgage banking segment our Fannie Mae risk sharing servicing portfolio has less than a 3% exposure to Houston as measured by unpaid principal balance. This consists of approximately $89 million in outstanding principal, again, all baked by seasoned performing apartment buildings. Overall, we have no loans in Houston collateralized by office, retail, industrial or lodging properties in either our principal lending or mortgage banking segments.

Finally, before I turn the call back over to Todd I just wanted to notes that we declared a third quarter dividend of $0.25 per common share payable on October 15th to shareholders of record on September 30, 2015. So with that I will now turn the call back over to Todd for some closing remarks,

Thanks, Tae-Sik. Before I conclude with some remarks on our outlook, I want to briefly discuss some very exciting news that Ares announced last week. Last Thursday Ares Management LP and Kayne Anderson Capital Advisers LP entered into a definitive merger agreement with the combined company to be named Ares Kayne which will become one of the largest and most diversified alternative asset managers with a combined $113 billion of assets under management as of March 31, 2015. The closing is anticipated to be on or around January 1, 2016, and will be subject to various customary closing conditions. The combined firm will invest across five complementary market leading investment groups which include tradable credits, direct lending, energy, private equity and of course real estate. We believe that the combination of these industry-leading teams will make us all better investors equipped with greater market knowledge, deal flow and capital access. In particular we are excited about the prospect of having the real estate equity group of Kayne Anderson join our existing real estate team at Ares. They are experienced high-quality group that we have come to know quite well both by reputation and as an Ares borrower in a transaction that we closed with them last year. We expect that their market knowledge and capabilities will enhance Ares' market presence and provide opportunities to bring value to our shareholders.

Before turning back to the operator, I want to address our plans for the business beyond 2015. During 2015 Ares has delivered strong earnings as many of the seeds that we planted in 2014 are bearing fruit. Yet as we look beyond 2015, we believe there are further opportunities for us to improve shareholder value by growing our earnings and this part is important with our available capital. As such we're focused on four points of execution to position our business for continued earnings growth. First, we're committed to growing the profitability of Ares capital. We believe our mortgage banking business can continue to generate expanding ROEs that are accretive to our principal lending business. Second, in our principal lending business we continue to see highly attractive investment opportunities to enhance our ROEs and of course we can now accretively invest in our own stock at current levels.

Third, we believe there are further opportunities to lower our cost of capital through refinancings of secured and unsecured sources of debt. The upcoming maturity of our $69 million convertible notes in December is a prime example. These notes have an all in cost of capital of 9.4% which is our most expensive form of debt capital. We believe that there are lower cost alternatives available to us. And fourth we are very focused on finding cost efficiencies to leverage our expenses. This quarter provides validation of our progress on expenses. As an example professional fees for the quarter are down 44% year-over-year. We continue to look for additional cost savings to be achieved in the future. Executing our business plan has resulted in three successive quarters of significant year-over-year earnings with a portfolio that is match funded and positioned to benefit from increasing interest rates and an expanding mortgage banking platform I believe the breadth of our business positions us very well for the future and by continuing to execute on our plans over the medium to long-term we believe that we can generate a repeatable, attractive and growing earnings stream. Lastly, we think the sale of one of our lowest yielding assets at par further substantiates the notion that there is meaningful value in our stock today.

I want to thank our investors for their support and would now be happy to take your questions.

(Operator Instructions). And our first question today comes from Steve Delany from JMP Securities. Please go ahead with your question.

Thanks for taking the question. Hello, everyone. I would like to start with the $75 million loan designated for sale in the quarter. I believe I read a comment in the deck, not the press release, that it was one much your lower yielding loans and it looks like it was about LIBOR plus 375. I am just curious along this theme of enhancing earnings with existing capital might we expect to see you do further culling of the portfolio moving forward? I noticed there is a retail loan as low as 325 over so maybe just a little color on what your flexibility is to do more of those type of loan sales going forwards. Thanks.

Thanks, Steve. Appreciate it. So, you know, we're in the business of making loans and keeping them on the books and generating returns for shareholders for taking appropriate risk and getting paid, hopefully, disproportionately for those investments and for the risk we're taking. So the simple answer to your question is we are not looking to sell any more assets. This was definitely if not our lowest one of our lowest yielding assets. It was also an asset of some size for us and we definitely thought this particular asset presented us with an opportunity to repatriate some capital and reinvest at higher ROEs and we also think it makes a really positive comment about the valuation of the assets in our book right now. So I don't think you're going to see my more asset sales from us but we think this was important and did a lot of good things for us.

And it was as you say a little lumpy and I guess having a more diversified if you split that into three loans, you have got a move diversified credit book and maybe even more objections on how to finance the new smaller loans.

Yes. And it frees up capital for that and it frees capital to invest in our stock if you choose as well so.

Right. Right. And you mentioned in the press release additional strategies to enhance earnings. I take it that that's what you gave us your four point plan and that's what you were eluding to the in press release, those four point of execution?

That's right. Yes.

Okay. So, Todd, the progress in Ares Capital is pretty remarkable and you are now running at -- I know it can be -- quarter to quarter can be seasonal but you are running somewhere $800 million to $900 million. Just as you see the business now and you see the kind of the tailwind the FHFA has given to the multi-family market with these new exclusions from the caps, I mean could this business -- I mean I'm trying to get a sense for the scalability from here. If we look out say 12 months from now, is it possible that the magnitude of growth there could be as much as a doubling of volume there given your platform and given the market opportunity?

So we don't -- you know, Steve, we don't give specific guidance around that, but I can --

Understand.

-- tell you -- I can tell you that I believe we're sort of still in the early stages of growth of that business and I think that business has a lot of growth potential ahead of it. In some respects we've only scratched the surface in other respects we've obviously made meaningful changes to the business that are really adding value to the shareholders now. I expect that business to grow and grow significantly over the next two, three years and I expect it to be in a position to not only grow its own earnings but to be a significant generator of business to the balance sheet as well. And that was one of the reasons we did the transaction. Another reason was that we thought it would be accretive from an ROE perspective and we are confident that that is the case. So we will -- again, I think we're in the early stages of continued growth for that business. And Fannie and Freddie obviously helped quite a built I mean the news around them and the caps and the relief under the caps has been pretty meaningful so all of that bodes well for the Company.

I think you maybe weren't aware of it when you made the acquisition, but it certainly has provided a huge point of differentiation between Ares and some of the other commercial mortgage REITs that are strictly portfolio lenders. And just one last little quick thing. So other -- you're doing business with all three agencies and it was really flies to see the HUD volume given the profitability there. But other than Ares Capital and Walker and Dunlop do you know how many other lenders are actively engaged with all three agencies?

So there are -- we know there's about 24 or so Fannie Mae dust lenders and we know there's about 24 or so Freddie Mac lenders and then within that if you kind of look at who is active with both licenses we think that number is 15 to 20. It's probably not quite 20. It's probably closer to 15 but somewhere in that range and then there's actually a lot of FHA licenses in the market but very few people have kind of what I would characterize as vibrant FHA businesses. And so if you kind of layer that into the 15 to 20, it's probably a number of 10 or so maybe less that have kind of all three licenses and are very active with all three licenses.

That's helpful. Okay. Thanks for the comments, guys.

You bet. Thanks, Steve.

Thanks, Steve.

Our next question comes from Dan Altscher from FBR. Please go ahead with your question.

Thanks everyone. Good afternoon at this point. You know, Tae-Sik, you mentioned and Todd you both mentioned the convert coming up in the script and the potential to I guess refinance that maybe at a little bit more of an attractive rate of the all-in effective 9.4. Can you give us maybe a sense as to what you think that could look like if that's the route you choose to go down and then I know it's only going to be minor if it's only for like a month or two but what plan is maybe incorporated into the new guidance or the revised guidance.

Sure. Good afternoon, Dan. Thanks for your question. In terms of the convert, as you mentioned and as we mentioned, we're actually very excited about the opportunity to refinance that form of debt. That was capital that we put in place more than two and a half years ago about eight months after we had completed our IPO at a time when our shareholder equity was approximately $160 million. So we are much smaller (inaudible) company with certainly a much smaller balance sheet. And the cost of capital at that time I think reflected the you know, somewhat growing stage of our business. So sort of apple to apple here we are two and a half years later our shareholder equity is $400 million our balance sheet is $1.5 billion so we do even if we were to replace it with similar type debt being a convertible note that we would shave a meaningful amount on the cost of capital. I don't want to give a pin point number, but we would estimate it to be certainly greater than 100 basis points difference. But, again I want to make it very clear that right now given our share price we would not be looking at a convertible note offering and so the options that I mentioned previously at this time at this share price do not include a convertible note as one of the options. Given again the fact that we do not want to offer common or equity link securities at today's share price. The options we are looking at would include other forms of debt financing as well as what we mentioned as given our current liquidity position plus what we think is a very -- a couple of upcoming maturities or prepayments of loans that we would have sufficient cash-on-hand to actually pay off the $69 million convertible note as well. So I think those are a little bit of more information on what we expect to do to pay off the convertible note. But I think given that it is our most expensive by a wide margin in terms of our cost to debt capital I think this really represents a great opportunity for us to lower our overall cost of capital.

Got it. Okay. No,- that was very clear. Thank you. Todd, question for you. You mentioned the idea of a share buyback a couple times in the script and obviously we know the repurchase authorization is in place. I guess we didn't buy back any stock in the quarter which is fine, but how did you weigh that decision not to do that as opposed to deploying capital organically into the business. And if the stock price happened to move up a little bit is that even still even an opportunity? I know you mentioned it is, but I would think you would want to try to get stock lower maybe than where it is now.

It's an interesting question. So we did not -- we weren't active in the buy back program in the past quarter. A part of that was just I would say tied to timing of when the program was put in place, certain restrictions around our ability to buy back stock. But let's not lose sight of the fact either that I mentioned a hotel investment for example that we made in the quarter. That's a mid-teens ROE. If those kind of opportunities continue to be available to us I mean obviously we have to take a long, hard look at that. So we're continuing the stock buyback is a real opportunity and option for us. We continue to evaluate it regularly against our capital avalibilty and against our other investment opportunities and we will continue to do that for sure.

Okay. Cool. And then just one other one I think also, Todd, in your remarks you mentioned how I think you think the overall product mix in Ares Cap is going to be maybe relatively similar or at least the margin is going to be relatively similar, which is good to hear. But on the volume perspective I think you have often said that in fourth quarter in particular is a bit seasonally heavier than maybe a third quarter is. Do you think that's kind of still the right way to think about it this year given that everything has been I guess maybe very -- I don't know if accelerated is the right word but has been very strong and constant throughout the entire year, has it maybe been a little bit more front end loaded than you might have thought in.

It's a great question. My thoughts around that are that Q3 and I have said this for -- I have been saying this for a few months now that you could see a dip in GSE production specifically Fannie and Freddie sort of industry-wide because of the way the sort of whole cap discussion is kind of working on people's pipelines.

Yes.

For us it's not going -- we don't view it as a material issue because in particular our FHA pipeline is so strong right now and we have been saying that for a while as well. So we like the prospects for our Q3, but I do think industry-wide you will see the Fannie and Freddie numbers come in a little bit. I think Q4 you could actually see meaningfully more production out of the GSEs for a variety of reasons and so I think that's sort of how the rest of the year will play out. So Q4 in particular could be very strong. You know, we will get more clarity and visibility on that over the next couple much month, but I have every reason to believe that Q4 could be quite strong and, again, our Q3 feeling very good about our Q3 just because of the way our FHA pipeline has materialized over the last few months.

Okay. Great. That's super helpful. Thanks so much. Keep up the good work.

Okay. Thanks, Dan.

Our next question comes from Jade Rahmani from KBW. Please go ahead with your question.

Hi. Thanks for taking my questions. Todd, I was wondering if you could give a view of the real estate cycle, the level of competition and if you're seeing any changes from how borrowers and sponsors are approaching the market given how strong pricing has been this year? And also you guys have an outsized concentration in multi-family and expertise in that space so I was wondering if you could comment on that as well as recently some equity REIT, prominent REITs have commented on supply increases in that market.

So let me take the second one first, Jade. And thanks for the question. So multi-family for us we have been big believers in multi-family for a few years now. Part of that is evidenced by the amount of our balance sheet that has multi-family investments in it. We also obviously made a purchase of a mortgage banking business that was multi-family centric in the form of Ares Cap a couple of years ago. So we have liked multi-family quite a bit. We continue to like the numbers from multi-family. Yes, there are markets, we have said this for several months now, where there is some supply coming on. But if you look at sort of supply over the last few years, it has been very low and we think the amount of supply coming on in general is fairly rational. Yes, there might be a couple of markets where it might get a little ahead of itself but as general matter we think the supply from multis is quite rational and we just think the demographic tailwinds is huge in that business from a demand side. If you just look at again everybody has quoted this statistic for quite a while but it is a very relevant statistic around the millennials and them coming of rental age. It's big number so there's a huge amount of demand. We think the supply is for the most part rational and we continue to be very bullish on multi-family. Now, as a general matter when you look at the cycle and where we are, look a lot of -- if you view cap rate compression as low-hanging fruit, I think in general across the various products that maybe the low-hanging fruit is mostly gone, right? But I do think you can continue to see some modest increases in valuations more from cash flow increases, occupancies increases, rental rates going up, those kind of things, but not so much from cap rate compression anymore. You might see a little bit of cap rate compression in various asset types or in B and C quality assets right now where people are chasing yield for the moment. But as a general matter I think commercial real estate values -- the increases in commercial real estate values have come from cap rate compressions is significantly over at this point and we're looking for value increases to come from cash flows and rents and occupancies.

Thanks for that. CMBS prices have been pretty volatile and I think there's notable spread widening late in the quarter. Did you see any spillover effects into the lending market and have you adjusted quotes you're providing on your loans?

So, you know, what we see in our mainline business for the Ares balance sheet isn't as sensitive to the CMBS market as you would expect. There is some sensitivity. Big movements will definitely push borrowers out of the CMBS market as their spreads widen and they think they are going into a financing at one spread and all of a sudden they are 30 or so wider but as a general matter we're not hypersensitive to that, so it hasn't had a meaningful impact on the spreads we're seeing in the market. As a general matter the way we are set up with direct origination system around the country we have really good market penetration, we're seeing a ton of flow way more flow than we have capital for right now, and as a result our ROAs are holding up nicely. Again, if you look at the asset we did in Q2 that's a prime example of the returns on that asset are going to be very nice, very accretive. So we're not seeing a dramatic move one way or the other from CMBS spreads in terms of when they were tightening it didn't really affect our ROAs that much and now that they have been widening they haven't affected our ROAs that much.

Thanks. In terms of originations mix for the principal lending business are you expecting to allocate more toward mezzanine preferred equity given the stronger returns on equity that those loans provide?

That's a great question and our subordinated debt portfolio has increased a little bit in size. I think it's up to about 14% or 15% of the overall portfolio right now. I think the best way to think about it, Jade is we're going to be opportunistic. Sometimes sponsors comes to us and they have just fabulous first mortgage financing and we don't want to sort of fight that. We want to embrace it. So we in effect use their financing as our financing and they will come in with some preferred equity over and above that. Other times there's a great opportunity to do straight up first mortgage and we will do that. So we're not looking aggressively to increase our preferred equity in mezzanine debt book, but we will opportunistically -- if there are opportunities in the market to do it I don't have any problem letting that percentage breathe a little bit.

Jade, maybe just one other quick clarification. As Todd San Diego we're very opportunistic about how we invest or what form we invest. In terms of the return on equity, ROE, I think we find that our returns on leveraging our senior loans versus the unlevered return on our preferred equity mezzanine are very comparable. As Todd said, that's the analysis we are always doing to so see where are we getting the best risk adjusted return, what type of financing is built into a mezz structure versus what type of financing are we able to get if we do a senior loan. Those are all of the factors that Todd mentioned that we take into at but overall we find that ROEs on senior and the ROEs on the mezz preferred equity are very comparable.

Thanks for that. And just finally on the dividend, given that earnings exceeded the dividend and your guidance implies earnings in excession of the dividend, how do you view prospects for a dividend increase and if there were some of the Ares Capital earnings distributed as a dividend would that portion of the dividend be taxed at the dividend tax rate since it is coming from TRS?

I'll handle the first part and I think Tae-Sik will handle the second part of that question, Jade. As it relates to the dividend and increasing the dividend I love that we are having this conversation, I love that we are in a position to have this conversation. From our perspective we look very carefully at a few things. But importantly we are looking at considering whether it makes sense to increase the dividend in future quarters and or increase book value. So we have the option as you know because of the way the TRS structure works to retain earnings retain our capital and build book value. So we are constantly evaluating that. We think building book value is obviously a good thing for shareholders. We get that increasing the dividend is also a good thing for shareholders and we are constantly trying to consider both those things and balance it out. But ultimately we would like to have a consistently growing dividend over time. I mean that is clearly a goal, one of our goals.

Jade, maybe to respond to the second part of your question about the taxability of div ends from the TRS up to the REITs as you know, the tax REIT subsidiary as its name implies itself is a tax paying entity so taxable income is certainly taxable at the mortgage banking business. But until -- unless and until the TRS taxable REIT subsidiary actually makes a dividend distribution to Ares the REIT Ares itself is shielded from the taxable income that is generated at the taxable REIT subsidiary. So that gives us great flexibility in terms of retaining earnings within the TRS and obviously we are responsible for paying taxes at that level, but it does not cause Ares to increase its taxable income so it does give us that great flexibility to either dividend out more cash and/or retain cash and continue to build book value within the TRS.

Thanks. That's helpful. Thanks for taking my questions.

You bet. Thank you.

Thanks, Jade.

Our next question comes from Rick Shane from JPMorgan. Please go ahead with your question.

Sure. A couple questions. Can we start on capital. Does it make any sense to increase the dividend given the discount to book value if you have earnings at the TRS? Doesn't it just make more sense to buy back stock?

Rick, I think that's exactly un one of the options that we mentioned. You know, certainly when we have cash, we have a number of options we can invest it in new held for investment type of assets, we can increase our dividend or as you mentioned we can buy back stock. And so I think one of the considerations that Todd mentioned that we are taking into account in terms of either increasing our dividend or keeping our dividend is exactly that. We now have another tool available to us to further build book value to further build EPS and buying back shares is certainly an available option to us for exactly the reasons you cited.

Got it. Okay. That's helpful. And then I guess the follow-up to that is given the refinancing of the converts, will you be more cautious about buying back stock until you have absolute visibilty on that just in order to preserve liquidity and make sure that you can act on -- you can grow the left side of the balance sheet opportunistically if you choose to?

Rick, absolutely. You know, in terms of managing our liquidity, managing our cash, managing our liabilities, we certainly have first and foremost the upcoming maturity of the convert so if we thought the risk to repaying that debt was high, we certainly would make sure we conserve all cash in order to make that debt repayment. But we feel that we are well managing our cash right now, we feel very good about the upcoming maturity and our ability to repay it, so we believe we have a number of options available to us. But as you mentioned, our first and foremost priority of cash for the next four or five months will be to make sure that we have sufficient liquidity to payback the convert. But as I mentioned, I think we feel very good about that and that we have the options, we will have additional cash to pursue other opportunities. I should also mention I'm not sure if I fully responded to an earlier question from Dan about our earnings guidance. Just to make clear that our earnings guidance and our increased earnings guidance does not take into account the fact that we would have to issue for example another convert to refinance the existing convert. If I didn't make that clear before I just wanted to reiterate that assumption that goes into our earnings model with respect to our earnings guidance.

Got it. I mean it strikes me that you guys -- that what we're describing here is a low frequency, high severity risk and it strikes me you guys are too conservative to take that on in the short-term. The other question -- I appreciate the guidance on gain on sale margin. As you guys know within our models it's a very sensitive metric where we don't necessarily have a tremendous amount of visibility so even just getting sort of a one quarter look really helps everybody tighten up their numbers. I am curious what you think are the observable factors for us that we should be thinking about that influence gain on sale?

An interesting question. Well, first of all the observable factor is I think we made clear in our remarks that we actually think that the Q2, 3 and 4 will be kind of consistent in the margins that we're going to generate in the business as compared to Q1, which was a lower -- at a different product mix and a lower margin. We've also rate locked in this quarter about $62 million to-date of loans and the combined margin on those is equal to or maybe even higher than the margin that we have shown for Q2 and so, again, that's supportive. I would say that one of the things that can impact margins is if you get volatility in interest rates. So interest rate vol can have impact on margins, so if you really wanted to just sort of look for an indicator, that would be one, but it's got to be pretty significant volatility. Rising rates in a kind of very moderate way not really that impactful, but it's the volatility and we have talked about this in the past that can have a real impact on margins. So I hope that answers your question.

No, it does, and again it underscores why that outlook for the next two quarters is so helpful to us. Thank you.

Yes. Thank you.

Our next question comes from Joel Houck from Wells Fargo.

Please go ahead with your question.

Thanks. I guess earlier in your prepared remarks, Todd, you made a comment regarding the accretion of the mortgage banking business relative to the principal lending. I am wondering if you can put a little more color on that. It strikes me as Ares is in a very unique situation one it's not been in since it went public and that is you don't really have to raise capital to grow earnings other than just being cognizant of the restrain in terms of the size of the mortgage banking business and the TRS. So with that in mind, can you put any numbers in terms of a relative accretion of that business versus the more traditional principal lending segment?

So I am not sure -- I am not going to give a specific number, but I will give you a couple sort of just generic data points maybe.

Okay.

So there is obviously we all know there is a pure-play in the space, publicly held one that I know of which is Walker Dunlop and their ROEs are probably mid-teens are so. So I think over time for us to get to those kinds of levels should -- that's a reasonable data point to look at.

Okay.

I can telling you that we are incredibly focused on building that business, on expanding, getting better all the time in that business bringing in better and better producers, becoming more and more efficient. So I think there's still meaningful upside for us in that business and we're very focused on growing it in part because of the capital like nature of it but in parts because we just see a tremendous opportunity in that space right now to grow it.

And is there any -- because you have the REIT TRS entity they don't is there any impediment to getting those types of returns in terms of how big you can get? In other words, obviously there's a huge scale advantage. I am just wondering how you guys have looked out and kind of thought about the returns relative to the size of how big the mortgage banking segment could actually be.

I think the balance sheet -- and once of the reasons if you think back to why we did the transaction to purchase Ares Capital to begin with, is the balance sheet is actually a huge benefit to the business, the synergies that come with that are tremendous. There's a lot of people in the mortgage banking space who would love to have a balance sheet and don't. So the balance sheet is a tremendous benefit. So and other thing that's interesting about our business maybe relative to some of our competitors is we have three primary products, two of them I would characterize as higher margin, one is a lower margin, right? And we're expecting sort of roughly a balanced production mix over the course of the year so on that basis roughly two-thirds of our mix will be higher margin product. That's probably not typical for some of our bigger competitors. So that we actually have working for us. The scale of courser is working against us a little bit, but over time that's the upside. The scale is actually the upside for us.

Okay. And do you guys disclose or mention at all like how capital is allocated between mortgage banking and principal lending?

Sure. I think we have indicated previously that the equity that we have in the mortgage banking business is really based upon, number one, the up front cash purchase price and the stock issued at the time we closed the deal in the third quarter of 2013 plus an additional working capital dollars that we have funded the company but it's just under 20%.

Okay.

I think the amount of capital that we have put into the mortgage banking business.

Okay. Great. Thank you. That's helpful.

Our next question comes from Ken Bruce from Bank of America Merrill Lynch. Please go ahead with your question.

Thank you, good afternoon. My question, and I apologize if this is redundant in any way, can you maybe give us a little bit more color around why you believe the gain on sale margins will be stable in the back half the year? I know you tried to tackle that with Rick's question, but I guess I am still a little left guessing as to why you feel that they will be stable when I think most of us recognize that there's this bit of spread volatility in the market already and that has an impact on gain of sale.

So it's a really good question. Thank you. Look, I think it has a lot to do with product mix, right? So again if you look at our first quarter, 60% of our business was in a lower what I would characterize as a lower margin product. In Q2 40% of our business was in what I would characterize as a lower margin product. And given the visibility we have in our pipeline going forward we're pretty confident that the product mix is going to work to the benefit of the shareholders here and to the benefit of margins relative to Q1. So that's really why we have -- that's really why we're saying it. It's really a product mix, a statement about the product mix going forward.

That's very helpful. So FHA, I assume, is essentially the driver of the higher margins versus the conventional?

Well, I would say -- again, we view -- we don't quote unquote have what we call we have a conventional product in the mortgage banking business we have FHA, Fannie Mae and Freddie Mac. We have said that FHA and Fannie are typically higher margin products and it's all relative obviously and that Freddie is a lower margin product. So we think we have good visibility on our FHA pipeline that has sort of a longer gestation period so we have got some pretty good clarity on that. We also think the Fannie Mae business is going to pick up towards the end of the year as well and Freddie Mac will hold pretty steady and that's how kind of how we are thinking about the business right now. It's pretty consistent by the way with what we have been saying for at least a quarter now. I mean nothing has really changed in that regard for at least a quarter.

Well, I guess it's nice to see the actual delivery of the higher margins in the quarter so that's helpful by itself. My next question and you -- I guess when you think about capital structure you have addressed a lot of different questions just in your prepared remarks around how you're thinking about capital and the like. I guess the thing that always seem a bit self imposed is the leverage level that you're really talk about between two to three times. I just wonder is there a capacity to be able to take that higher should you see fit to so?

Sure. Ken. I think we look at leverage levels certainly on a consolidated basis the way it's being reported to the shareholders and certainly the way it's being reported for debt compliance as well. But truly at the end of the day the way we optimize the leverage if you want to call it that is we really look at it loan by loan, deal-by-deal. So for example if we have the opportunity to put a loan on a senior mortgage-backed by a very stable multi-family asset, I think we feel very comfortable going up to four to one, maybe even higher. When we did our collateralized loan obligation and securitization transaction about a little less than a year ago, we actually achieved leverage better than four to one in that financing and we thought that was a very attractive and appropriate level of debt-to-equity because it was non-recourse, it was match-funded. It was for lack of a better word sort of the permanent debt capital match funding the term of the anticipated underlying collateral. So when we have situations like that, we feel decree comfortable going over four to one or even other sort of stated levels. In other situations for example when we have loans that are preferred equity or mezzanine positions we have not directly financed those positions on a loan by loan basis. So, again, I think we really tailor our leverage levels loan by loan or asset by asset. We certainly look at it on a consolidated basis. We certainly have covenants that we need to meet on a consolidated basis which are significantly higher. It's really at the four to one on a consolidated basis with no more than three to one for recourse debt, but, again, we really look at leverage on a dealing by deal basis.

Okay. Thank you. And then I don't know if this is disclosed anywhere but what was your taxable income in the quarter?

Our taxable income if you look at the segment analysis, so our taxable income there's a tiny bit of income taxes for our principal lending business but obviously it comes primarily from our mortgage banking business which is held in the taxable REIT subsidiary. So if you look at the pre-tax income, it was $2.9 million, $2.938 million, the accrued income tax expense is $757,000, therefore, had net income after-tax of $2.181 million for the taxable REIT subsidiary.

Okay. I'm sorry. I guess I misstated that. So what would be the in terms of the REIT taxable income that would kind of derive the dividend?

I'm sorry. I misunderstood. Unfortunately that we have not disclosed and, again, we really calculate that on an annual basis, not quarter to quarter basis. There are a number of M1 adjustments from our GAAP income to our taxable income so net income is a good directional view of taxable income, but it's not a precise view of taxable income.

Okay. Well, thank you for your comments and congratulations on another very good quarter. So glad to see that and hopefully the market will start to recognize it.

Thanks so much, Ken.

Thanks, Ken.

(Operator Instructions). Our next question comes from Doug Harter from Credit Suisse. Please go ahead with your question.

Thanks. In your prepared remarks you talked about getting some expense leverage. I guess where would you say you are in that process an do you think there's room for more?

Sure. I think it's a great question and an effort that we have had ongoing for several periods now. You know, as Todd mentioned there's certainly great examples of where we have already achieved some significant cost savings, professional fees being the example that he cited. So there's really what I call sort of two-ways to benefit from potential expense savings. One is just the absolute reduction in costs. We have taken a very specific analysis and effort to make sure we look at every one of our expense line items, whether it's D&O insurance, whether it's professional fees related to legal counsel, audit, any vendors we work with. We have looked and continue to look at all of those line items. Any out of pocket costs, any sort of consulting expenses, again, we have taken a very, very hard look at it with the eye towards obviously minimizing those expenses and making sure that every dollar we spend is to help increase our overall revenue and our overall ROE. So that's really what we call sort of the first level. The second level is as we continue to build out our balance street we obviously have not grown our equity but we have grown our assets over time and as we have done that, we will release and continue to realize the fact that a significant portion of our expenses are fixed. And so I a good example of that would be D&O insurance. As you can imagine D&O insurance is a very expensive cost to us being a public company all-in it's approximately a million dollars a year for D&O insurance.

The good news if you want to call it that with D&O insurance we expect is that even if we were to grow our Company further so if we grew revenues by 50%, if we grew assets by 50%, and at some point hopefully we will grow our equity by some percent, we would not expect our D&O insurance to increase significantly. We certainly would not expect it to grow proportionately with our revenue, with our assets, with our equity. So that's really the second form of expense savings through scale that we would expect going forward as well.

Great. Thank you.

And, ladies and gentlemen, at this time we will conclude our question-and-answer session. I would like to turn the conference call back over to Todd Schuster for any closing comments.

Just want to thank everybody for being on the call today. We are obviously very proud of the quarter and are very excited about the future of the Company. And we look forward to speaking with all of you soon about those exact things. Take care everybody.

Ladies and gentlemen, this concludes our conference call for today. If you missed any part of today's calling an archived replay of this conference call will be available approximately one hour after the end of this call through August 12, 2015 to domestic callers by dialing 877-344-7529 and to international callers by dialing 1-412-317-0088. For all replays please reference conference number 10067139 an archived replay will be available on the webcast link located on the home page of the investor resources section of our website. Again, we thank you for attending. You may now disconnect your telephone lines.