2023-05-21 06:44:49 ET
Summary
- There is a significant amount of new multifamily real estate coming on-line in this already struggling sector this year, rents are likely to trend flat to negative this year.
- The cap rates for multifamily properties are now dangerously low, many companies with bridge loans will likely have trouble refinancing the bridge loans Arbor Realty specializes in.
- The Fed is likely to continue to raise rates in 2023 even though a recession looks increasingly likely, vacancy rates are being forecast by analysts to increase at multifamily properties.
- The company looks overvalued using several metrics.
Markets can be fragile. While most risk assets such as real estate and equities performed very well over the last decade, the economic and investing environment has changed dramatically in the last two years with interest rates rising significantly. Many industries rely on small margins, and slight adjustments in financing costs can still make significant differences in overall profits.
Few industries have been impacted more by rising interest rates than the real estate industry. Many REITs rely on debt-heavy business models to finance operations, and even incremental increases in financing rates can create major challenges for these companies. The multifamily real estate industry is a lower margin part of this sector that has been hit particularly hard by the impact of rising rates is. Cap rates in the multifamily real estate market tend to be about a half a percent to a full percent lower than levels normally seen in commercial and other real estate markets even during good times, so a slightly increase in costs and liabilities can have a big impact on this industry.
A chart showing cap rates (CoStar)
Arbor Realty ( ABR ) is a financial leader company that has significant exposure to the multifamily real estate market. Arbor Realty mostly holds bridge and mezzanine loans in this sector, and nearly 98% of this company's loan portfolio are bridge loans, and 91% of that financing is for multifamily real estate.
Today, Arbor Realty is in my view a sell. The cap rates and internal return rates of most multifamily real estate properties is dangerously low right now, and the Fed is likely to continue to raise rates with inflation rates still coming in high at 4.9%. Rents in this sector should also be flat to negative with record amounts of new multifamily real estate expected to come on-line this year and increasing signs that the economy is slowing . Arbor Realty's leverage and the lender's significant exposure to bridge and mezzanine loans has made this company very vulnerable to even moderate weakness to this real estate market.
A chart of cap rates (Cushman and Wakefield, Green Street)
The two main problems the multifamily residential sector faces right now are higher financing costs with rates going up, and an over-supply of multi-family units putting pressure on rent and property valuations. Cap Rates in the multifamily real estate market for many properties have now fallen below the rate to finance these buildings because of interest rate increases, and a record amount of new multi-family real estate developments are also supposed to come on-line in 2023.
A Chart showing construction levels of multi-family residential properties (JPMorgan)
With rates low, pent-up demand for housing coming out of the pandemic , and many families priced out of the expensive single family home market, massive new developments of multi-family real estate projects were undertaken over the last two years to keep up with the high demand for this kind of housing. Supply chain problems and labor shortage issues prevented a lot of these new buildings from being completed in 2021, but a good amount of these projects have now been finished, and many more are scheduled to come on-line this year. The construction of multi-family real estate buildings has now reached hit a 36-year high, even as sales in multi-family real estate sector fell earlier this year to the lowest levels seen since 2008, dropping $40 billion in the first quarter of 2023, as compared to the same time period in 2022. High rates have provided an incremental benefit to part of Arbor Realty's servicing business, which brings in nearly $90 million a year, but rising interest rates have still hurt this company's business model significantly overall.
The multi-family residential market will likely become even more significantly over-supplied this year, and there are also increasing signs of an economic slowdown. Moody's forecast is for vacancy rates in multifamily homes to rise from 4.4% to between 5.5-6% if there is an even moderate recession, which seems more likely given the recent economic data . That means that if the Fed remains committed to raising rates, cap rates in the multi-family real estate industry could fall well below financing rates. Powell isn't likely to reverse course anytime soon with April's inflation data coming in at 4.9%, well above the Powell's stated goal of 2%. Many of Arbor Realty's bridge loans also have a duration of 1 to 3 years, or less. If the owners can't refinance, the company was forced to take possession of these properties at prices that likely will mean a significant loss.
This is why the company's recent foreclosure proceedings of some of the lender's holdings are important. Arbor Realty was forced to recently foreclose on several multi-family properties in the Houston area valued at $229 million. Sometimes developer's default and foreclosures are necessary in this business, but what was interesting about this situation is that when the properties went to auction on April 4th, and there was not a single bidder. Arbor Realty took possession of them using a credit bid where the company didn't have to put up cash to bid for the properties since the company was able to use the debt they held as collateral on the buildings for management's bid. The fact that not a single person or company was willing to even put a bid out for these properties should be concerning to investors. Even though Arbor Realty had $800 million in cash at the end of 2022 and nearly 70% of the lender's secured debt is in a long-dated CLO format ,a small increase in interest rates from current levels would make the cap rate of many multifamily properties notably less than the cost to finance these assets.
Arbor Realty's business model also uses a significant amount of leverage, and the firm's long-term debt levels are near a 10-year high .
A Chart showing Arbor Realty's increasing long-term debt (Macrotrends)
Management levered up to pay high yields and inflate the net asset value over the last several years. This strategy worked well when rates were low and the real estate market was strong, but the fundamentals of this industry are now falling apart at the wrong time for this company's risky business model, and rates are likely to continue to go up. Arbor Realty's leverage ratio in the first quarter of 2023 was 4.3, which is significantly higher than the company's leverage ratio of 3.52 in the first quarter of last year.
Arbor Realty also looks overvalued using several metrics. The company currently trades at 11x trailing cash flow and 3.13x trailing sales. The sector average is 5.83x trailing cash flow, and 2.17x trailing book value. Arbor Realty's debt to capital ratio is also double the industry average at 80.61% because of the leverage the company uses, and the fund's loan portfolio also has greater risk because of the company's significant exposure to the softening multi-family real estate market. Arbor Realty's payout ratio is more conservative at 70%, but the company also holds over $2.4 billion in short-term loans subject to margin calls in a deteriorating market.
Many leveraged companies and funds within conservative industries are having trouble with rates moving higher, Arbor Realty's high risk business model puts the lender at unique risk in this interest rate cycle. The company's strategy looked prudent in the low rate cycle we were in prior to 2021, but management's business model looks reckless today. While the Fed reversing course of the economy avoiding a recession would obviously change the operating environment significantly for Arbor Realty, these scenarios seem unlikely, and this company doesn't have a lot of time to fix the lender's troubled business model.
For further details see:
Arbor Realty: A Sell, The Multifamily Real Estate Market Is In Trouble