ABR - Arbor Realty: Why Pessimistic Investors Messed Up (Downgrade)

2024-01-02 13:30:00 ET

Summary

• Arbor Realty Trust investors experienced a significant rally, recovering most of its losses from its July 2023 highs.
• The company outperformed analysts' estimates for its third-quarter distributable EPS, indicating strong performance amidst sector-wide challenges.
• ABR's agency business is expected to experience a significant growth recovery as interest rates drop, bolstering its outlook for 2024.
• I explain why pessimistic investors who focused on the 10Y yield when it was above the 5% mark failed to do what every investor should do: Anticipate.
• With the 10Y down to 3.87% last week, the upward re-rating in ABR is justified, and its near-term upside seems reflected.

Leading multi-family mREIT Arbor Realty Trust, Inc. (ABR) investors who braved the pessimism in ABR as it fell toward its December lows have been rewarded. Accordingly, ABR staged a remarkable rally from its early December low of $11.8, rising above the $16.3 level in just over four weeks. As such, it helped to recover most of ABR's losses from its July 2023 highs, as investors suffered a decline that lasted nearly five months, as the 10Y ( US10Y ) peaked in October 2023.

Notwithstanding the challenges Arbor Realty Trust faced in 2023, it outperformed analysts' estimates on its distributable EPS for its third-quarter or FQ3 earnings release in late October. ABR suffered a post-earnings decline, which surprised one of the analysts at the earnings conference, as he questioned "what aspects of the company's performance or market conditions might be misunderstood by the investment community."

However, management pointed out to the analyst that the company "cannot provide specific insights into why the market reacted in certain ways." Despite that, Arbor Realty Trust underscored several key performance metrics, suggesting the mREIT "has outperformed its peers, indicating strong company performance amidst sector-wide challenges."

However, with ABR's Q3 results more than two months old, I urge investors to refrain from relying on old information to make forward-looking projections about Arbor Realty's performance moving ahead.

Notably, while ABR didn't bottom out in late October, it was close to peak pessimism despite the post-earnings selloff. Its October low of $12.1 was close to its December low of $11.8. As a result, I gleaned that the market likely shook out weak holders who anticipated Arbor Realty could face significant challenges as the 10Y broke above the 5% mark in October.

However, these investors messed up because they focused on the past and present without trying to anticipate whether ABR could bottom out (lack of forward-looking insights), as the 10Y stunned the market when it surged above 5%. Observant investors would have assessed the price action in the 10Y, as management had already provided the clues as to why.

Recall from Arbor Realty Trust's earnings call as management responded to an analyst question: "What level of decrease in the 10-year rate is needed for a significant increase in agency business." If you aren't familiar with ABR's agency business, you should. The company's agency business remains the company's key origination vehicle, as it drove $1.15B in loan originations in Q3, well above the $240.2M driven by its structured business.

In addition, management stressed that a "drop in interest rates would significantly boost the company's agency Business." CEO Ivan Kaufman noted that the company's "agency business will explode" as it facilitates the conversion of the floating rate loans to fixed rates. The unprecedented rate hikes have also led to a significant slowdown in this segment, as borrowers face "significant stress, especially for borrowers planning to transition from variable to fixed-rate loans."

Therefore, I believe the market has revalued ABR markedly in response to the turnaround of its core agency business, unlocking more robust growth opportunities, as the Fed is expected to cut rates in 2024. The company also clarified that the "agency business will experience growth at each incremental drop in the 10-year rate." In addition, the boost would be significant as the 10Y "continues to drop to 450 basis points." As a result, the growth in the agency business could "potentially explode in volume as the rate decreases further."

With the 10Y last printed at 3.87%, the improvement is likely more significant than management and analysts projected. As a result, I expect management to provide a more robust outlook in its Q4 earnings conference. However, with ABR recovering most of its losses from its July 2023 highs, has its near-term upside already been priced in? Could dip-buying investors use the opportunity to take profit after a stunning recovery? What did I glean from ABR's price action?

ABR last traded at a forward distributable EPS of 8.1x, well below its 10Y average of 10x. In other words, while ABR has recovered from its recent lows, the market hasn't fully normalized its valuation toward its long-term average. I assessed that it's appropriate for now, as I don't expect interest rates to drop back to the pre-COVID lows in the near- and medium-term. In other words, I gleaned that the near-term re-rating in ABR seems reflected, suggesting its risk/reward profile appears well-balanced.

Furthermore, ABR's price chart suggests investors returned in a hurry after it bottomed out in December. Astute dip-buyers recognized the potential growth opportunities for Arbor Realty Trust's agency business from a rapidly declining 10Y.

However, I assessed profit-taking intensified last week, as ABR is expected to continue facing selling resistance at the $16.3 level. Therefore, I welcome a healthy pullback to help improve its entry point. Despite that, I must highlight that ABR's forward dividend yield of 11.4% seems robust and isn't expected to face imminent risks of a cut, given the welcomed boost to its core agency business.

Hence, income investors who aren't perturbed by near-term selling pressure will likely find the yield attractive enough to add more shares, helping ABR to consolidate more constructively at the current levels. Despite that, as a price action investor, I don't prefer to chase if I assessed that the risk/reward profile doesn't seem attractive enough from a total return perspective (including potential capital gains). Consequently, I will await a more attractive entry point and reassess ABR.

Rating: Downgraded to Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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