2023-07-12 08:05:00 ET
Summary
- We are recycling capital from one REIT to another.
- We are selling one REIT that has reached our fair value target.
- And we are reinvesting the proceeds into a new opportunity.
It is quite rare for us to sell a position.
We recognize that real estate investment trusts, or REITs ( VNQ ), are real estate investments and it typically takes years, not months, for our investment theses to play out.
Therefore, our ideal holding period is >3 years and it is not uncommon for us to hold on to winners for a lot longer than that.
We are landlords, not traders. (That's why we called our Investing Group: High Yield Landlord...)
But there are exceptions when selling may make sense.
- A REIT may become extremely overpriced. That's quite rare.
- Some risk factors may play out. That's more common.
- Or another REIT may become more opportunistic, forcing us to reconsider our portfolio since our capital is limited.
Recently, we divided to sell our stake in Welltower ( WELL ) primarily because our capital is limited and it is not the best use of it at this time.
We initiated our position during the early days of the pandemic when its share price was heavily discounted, but its valuation is not that low anymore:
Today, Welltower is priced at 22x funds from operations ("FFO"), which is reflective of its blue-chip characteristics. The company enjoys strong growth prospects right now because its senior housing assets are still recovering from the pandemic, but it appears that the market has already priced in most of that growth.
Moreover, the company also owns a lot of medical office buildings and most REITs that own such properties are today priced at much lower valuations. The leader in this space, Healthcare Realty ( HR ), is priced at just 12x FFO at the moment.
As a result, the risk-to-reward is now a lot less compelling than it used to be, at least relatively speaking.
At the same time, some news just came out concerning Arbor Realty Trust and we needed to unlock capital somewhere to buy more of its preferred shares.
For this reason, we sold our position in Welltower, locking our gain following its recent surge, and reinvested the proceeds into the Series F preferred shares of Arbor Realty Trust, doubling the size of our position.
Why invest in ABR.PF?
Arbor Realty Trust, Inc. ( ABR ) is an internally managed REIT that has been one of the most successful short-term commercial mortgage lenders on the public market.
In February 2023, our macro analyst, Austin Rogers, wrote an article explaining ABR's formula of success and why it has so strongly outperformed over the last 10 years.
As you can see above, ABR's total returns over the last decade have trounced both the equity REIT index and the mREIT index ( MORT ) as well as commercial mREIT peers like Ladder Capital ( LADR ), Blackstone Mortgage ( BXMT ), and Starwood Property Trust ( STWD ).
What has ABR's secret formula been? It stems from a few things:
- Management is highly experienced, long-tenured, and heavily aligned with shareholders, as insiders own 12% of the company. The CEO and other insiders recently bought more shares on the open market as recently as mid-March.
- ABR focuses almost entirely on residential lending, which minimizes the boom-bust cycle and makes its loan assets more stable.
- ABR generates significant revenue from low-risk business segments like loan origination and loan servicing that provide annuity-like income streams in addition to the residential CRE loans that it keeps on its balance sheet. Most of the non-owned loan book is serviced for government agencies like Fannie Mae and the FHA.
- Over half of its loans are secured by properties in the four of the hottest Sunbelt states of Texas, Florida, Georgia, and North Carolina.
The vast majority of the loans ABR holds on its balance sheet are high-yielding and floating-rate bridge loans, which typically span the 2-3-year "bridge" between a construction loan and long-term financing.
You also might be surprised to find that, despite sporting a dividend yield that is typically in the area of 9%, ABR's payout ratio in 2022 was only 67%, and the mREIT has increased its dividend for 10 consecutive years.
Arbor's Risk Profile
That said, ABR does have some risks to it. The stock price would not be currently offering an 11.5% dividend yield if it didn't!
The primary risks come from the fact that: (1) the value of the real estate securing its loans could fall; and (2) the revenue derived from those (mostly residential) properties may not be as high as was underwritten before the loan was extended.
On the first point, keep in mind that multifamily properties are coming off of the red-hot prices and ultra-low cap rates at which they traded in 2021 and much of 2022. And yet, during this time, ABR grew its balance sheet loan portfolio massively: over 120% in 2021 and around 30% in 2022.
Combining the fact that residential property values are falling with the fact that ABR's average balance sheet loan-to-value stood at 76% at the end of 2022 could mean that some properties LTVs will creep up too high. What happens when they get too high? Either:
- The borrower will have to infuse cash-equity to lower the LTV, somewhat like a margin call
- The borrower will default on the loan, and the property will revert to ABR
- There will be some restructuring arrangement that will cause ABR to take some degree of loss
These scenarios aren't devastating on their own, but keep in mind that ABR is heavily leveraged itself. All mREITs use leverage. When your assets are leveraged, it doesn't take as much losses to trigger a negative chain reaction.
Now also consider that a large portion of ABR's loans were originated in 2021 and 2022, when residential rents were increasing at a rapid rate. If those loans were underwritten with assumptions that rent would keep going up without taking a breather this year, they could prove to have been too aggressive.
More Conservative Alternative To Common Shares: Series F Preferred Stock
We are not pitching ABR's common stock today, because we are still in the middle of a chaotic period in the financial markets. Until more clarity is gained on where residential property values will land and how well ABR's recent loans will perform, we cannot recommend the common shares, especially to conservative and income-oriented retirees.
However, we recently came across a very interesting and unique opportunity to tap into Arbor Realty's relatively defensive (for an mREIT) cash flows that we believe provides much greater safety as well as a 7.9% yield and 20%+ upside to par/redemption value.
We are referring to the very unique Arbor Realty 6.25% Series F Fixed-To-Floating Cumulative Redeemable Preferred stock ( ABR.PF ) . (Boy, that's a mouthful.)
With 8.05 million shares outstanding, ABR.PF has a market capitalization of about $200 million at par, which represents significant liquidity for a preferred stock. As such, investors should not have an issue buying or selling shares, although it may still be a good idea to use limit orders.
Also good to keep in mind is that the $200 million of capitalization for ABR.PF and $657 million of combined capitalization for all three of ABR's preferred stocks makes up only 1.2% and 4.0%, respectively, of ABR's total enterprise value of ~$16.4 billion.
ABR's preferreds are a relatively small part of the capital structure and thus the preferred dividends should be fairly easy to keep paying without interruption.
Notice also that only ~$350 million of fixed-rate debt (2.7% of total debt) matures this year or next year.
What makes this preferred stock particularly interesting is its 5-year fixed dividend set at a 6.25% coupon yield at par value followed by a switch to a floating rate feature after those five years are up.
ABR.PF was issued in October 2021, and its call date (the first date at which management can , but does not have to, redeem the shares at their $25 par value) comes in October 2026. If management does not immediately redeem ABR.PF at this call date, the fixed dividend will switch to a floating rate feature.
Here's what the prospectus term sheet says:
(i) From and including the original issue date to, but excluding, October 30, 2026 (the “Fixed Rate Period”), at a fixed rate equal to 6.25% per annum of the $25.00 per share liquidation preference (equivalent to $1.5625 per annum per share) and (ii) from and including October 30, 2026 (the “Floating Rate Period”), at a floating rate equal to a Benchmark rate, which is expected to be the Three-Month Term SOFR (as defined in the Preliminary Prospectus Supplement), plus a spread of 5.442% per annum of the $25.00 per share liquidation preference (the “Floating Rate”); provided, however, that in no event shall the Floating Rate be lower than 6.125% per annum.
So, more succinctly, we can summarize how ABR.PF's preferred dividend works:
- 6.25% at par value ($25) from now until October 30th, 2026
- Thereafter, a floating rate of 3-month SOFR plus 5.442% with a floor of 6.125%.
As of July, the 3-month SOFR sits at 5.29%. If the floating feature kicked in today, it would trigger a floating rate of about 10.7% at par. That is far higher than the fixed coupon yields of ABR's other two preferred stocks that do not have fixed-to-floating features.
- Arbor Realty Preferred Series D ( ABR.PD ) - 6.375% at par
- Arbor Realty Preferred Series E ( ABR.PE ) - 6.25% at par
But notice that the 10.7% yield at which ABR.PF would trade if the floating feature was in effect today is at par . But ABR.PF is trading at about a 20% discount to par! So, the yield at present value would actually be ~13%!
Of course, the floating rate feature is not in effect today, so instead the yield at present value (based on a par yield of 6.25%) is about 7.9%.
Earning a relatively safe 7.9% yield plus 20% upside to par sounds like a pretty good deal to us.
We view ABR.PF as offering superior risk-adjusted returns as its two preferred siblings because of that floating rate feature that kicks in at the call date. Why? Let's think through the various scenarios:
- If interest rates drop back down to the ultra-low levels where they were when ABR.PF was issued and if the 3-month SOFR drops to or under 0.683%, then ABR.PF's downside is protected by that floor of 6.125%.
- If the 3-month SOFR remains as high as it is today or goes even higher by October 2026, then ABR.PF's floating rate will be in the double-digits. That would obviously be very nice for shareholders for as long as it lasts, but management would also be very motivated to redeem this pref series as soon as possible.
- If the 3-month SOFR comes down from its current level but doesn't go all the way back to the sub-1% area, then ABR.PF shareholders will enjoy a nice 7-9% floating rate yield after October 2026. Management may or may not call it, but they would likely choose to redeem ABR.PF before either of the fixed-rate prefs because it would cost the company more than the other two.
In other words, ABR.PF looks a lot more attractive than its sibling prefs because it is far more likely to be redeemed at or near its call date in October 2026. And since it's more likely to be called, it is more likely to enjoy its full 20% upside to par value between now and then.
Considering the 3 years between now and October 2026, that comes out to ~15% annualized total returns.
"Change Of Control" Provision
Ever since the debacle with Cedar Realty's preferred stock enduring a "cram down" by the acquirer company, Wheeler REIT ( WHLR ), preferred stock investors have understandably been cautious about the "change of control" provisions for REIT preferreds.
Here's the relevant section of ABR.PF's Form 8-A :
Notwithstanding anything to the contrary contained in Section 6(a), upon the occurrence of a Change of Control (as defined below), the Corporation may, at its option, upon not less than 30 nor more than 60 days’ written notice, redeem the Series F Preferred Stock, in whole or in part within 120 days on or after, the first date on which such Change of Control occurred, for cash at a redemption price of Twenty-Five Dollars ($25.00) per share, plus any accumulated and unpaid dividends thereon to, but excluding, the redemption date, without interest.
What exactly counts as a "change of control"? Two conditions must be met:
- ABR must be wholly acquired by a third party entity
- The acquirer is not publicly traded on any U.S. stock exchange.
So, what happens if the acquirer is publicly traded? In this case, the provision triggering liquidation-at-par of the acquiree's preferred stocks doesn't occur, and the acquirer can simply leave the acquiree's preferred stocks in place.
What happens when you have a really scummy, publicly traded acquirer who buys out the acquiree with no intention or ability to pay the acquiree's preferred stock dividends? That's exactly what happened in Wheeler's acquisition of Cedar Realty.
Wheeler already had an extremely poor record when it comes to shareholder value. The common shares had already stopped paying a dividend before the Cedar Realty acquisition deal was announced, so Wheeler management didn't need to worry about the requirement to pay preferred dividends before paying common dividends. They appear to have no intention or ability to pay either. Wheeler already has its own preferred stocks for which it is simply allowing unpaid dividends to accumulate.
What are the odds of something like this happening to ABR and its preferred stocks?
Answer: Incredibly low .
Why? Multiple reasons:
- Cedar Realty was a very small REIT. It's acquirer, Wheeler, was even smaller. The kind of sordidness required to acquire another company knowing full well you have no intention or ability to fulfill the obligations toward its preferred shareholders is extremely rare in companies much larger than Wheeler.
- Companies large enough to acquire ABR (currently $1.94 billion in market cap) most likely would not or could not bear the reputational damage that would follow from screwing over its preferred shareholders in this way.
- The management team of the acquiree would also like be aware of the likely outcome for their preferred shareholders in such a case as well. Thus, this kind of negative outcome for pref shareholders would also require a certain degree of sordidness from the acquiree's management. We do not view ABR's management team, led by founder and CEO Ivan Kaufman, as being willing to bear this kind of reputational damage.
Also, keep in mind that if ABR is acquired by a private company (not publicly traded on a U.S. exchange), ABR.PF shareholders have the right to convert their preferred shares to common shares at a conversation rate of 2.655 common shares per each preferred share.
Bottom Line
We rarely sell positions, but sometimes, it helps to be active.
Today, ABR.PF offers much better risk-to-reward than WELL in our opinion and for this reason, we recently sold WELL and reinvested the proceeds into ABR.PF.
For further details see:
1 REIT To Sell And 1 REIT To Buy