2023-08-18 05:16:18 ET
Summary
- Arbor Realty Trust had a good second quarter, with a marginal increase in book value and a dividend hike.
- The company's non-performing loans increased significantly in the first two quarters, which may pose challenges in the next two quarters.
- ABR's business strategy involves multiple lines of business, including multi-family mortgage loans, servicing rights, and single-family rental financing.
- We revisit our allocation to ABR.PF at the end of March and update our stance.
In this article, we revisit the mortgage REIT Arbor Realty Trust (ABR) in the context of our original allocation to the preferreds at the end of March this year. Investors may recall that towards the end of Q1 the company was hit by a combination of systemic worries about the real-estate market as well as a short-seller attack.
Last March, we allocated to the Series F ( ABR.PR.F ) preferred by rotating capital from a number of other hybrid mREIT preferreds. Although the stock's yield was not particularly high at that time in the sector at 9.3%, its relative valuation was very attractive. Historically the stock traded rich to the mREIT sector but a confluence of events pushed up its spread to the sector average. We viewed this event as a great opportunity to add the stock to our Income Portfolios.
Below we take a look at what's happened to the business over Q2, revisit the company's business model for investors unfamiliar with the name, review the relative valuation of its preferreds stack and update our stance.
Q2 Update
ABR had a good second quarter . Book value rose marginally while net income fell somewhat. The company hiked the dividend , resulting in a payout ratio of 75%.
The multi-family bridge loan business had a sizable $685m runoff, about two-thirds of which was recaptured into new agency loan origination, unlocking about $125m of capital. The GSE agency business originated $1.4bn of loans as the pipeline remains elevated due to the inverted yield curve. The fee-based servicing portfolio grew another 2% and generated around $118m in annualized terms in recurring cashflow. And the escrow balances are earning around $125m a year. Overall, these were very good results in a relatively difficult period for mortgage players.
Something to keep an eye on is the sharp jump in non-performing loans from $3m to $124m over the first two quarters. Against this rise, the company booked a $5m loan loss reserve against one of the loans. The other two loans the company views as money-good.
The overall level of non-performing loans is still very small in the context of the company's $16bn of total assets. However, management believe that the next two quarters will be particularly challenging for the portfolio. High cost of labor and a high level of economic vacancy are putting serious stress on borrowers and these developments are likely to create significant headwinds for business performance.
Business Strategy Recap
In this section, we briefly revisit the company's relatively unusual business strategy in the broader mortgage REIT sector.
Whereas a typical mREIT is, in effect, a portfolio of mortgage assets, whether Agency MBS or whole-loans, ABR has a number of different business lines.
The company's primary business is to originate and sell mostly multi-family mortgage loans whether through the Agency channel for conforming loans or through CLO securitizations for private label loans. The company also retains servicing rights for most of the loans it originates which provides another business line. Servicing also incorporates the income on escrow deposits held on behalf of borrowers, generating a riskless fee stream.
The inverted yield curve drove a lot of the balance sheet runoff last year which is positive for freeing up capacity elsewhere, however, it does limit the growth of its bridging finance in the near term given it's much more expensive relative to term loans.
For this reason, the company is putting a lot of focus on its single-family rental or SFR business. This line involves providing construction, bridge and permanent financing for single-family rental housing. The loans are to borrowers looking to purchase or develop rental properties with either permanent financing or bridge / line-of-credit financing.
This multi-pronged business strategy has two benefits over the traditional mortgage REIT. One, it is relatively diversified across a number of different lines. And two, the business generates significant income in a relatively capital light fashion, specifically, its origination, escrow and servicing lines.
This is in contrast to a traditional mREIT model where all of the income is generated by leveraged assets on the balance sheet. Admittedly, ABR strategy is not totally unheard of as RC, PMT and RITM share its elements, however, it does provide a nice diversifier for investors with allocations to more traditional mREITs.
Performance Review
At the end of March, we moved capital into ABR.PF from three other mREIT hybrid preferreds. Since then the stock has performed very well, returning around 24%, only second to KREF.PA (KREF.PR.A).
The chart below shows what this looks like in credit spread terms. At the end of March, ABR preferreds were trading at credit spreads roughly comparable to the broader sector. This may not seem overly compelling but this was unusually cheap for ABR whose preferreds have tended to trade at much tighter spreads historically.
Over the last couple of months this historic relationship reestablished itself with ABR preferreds moving to their usual and significantly tighter spread than the broader mREIT preferred sector.
What this means is that the unusual margin of safety for ABR preferreds has largely dissipated. This doesn't necessarily mean the preferreds should be sold but it does mean that the position may need to be pared down.
Relative Valuation
ABR has three preferreds summarized in the table below.
Systematic Income Preferreds Tool
Our view back in March was that ABR.PF was the most attractive in the suite. This was based on the following forward yield profile. Specifically, F required a small give-up in yield today but offered an enormous potential yield advantage a few years in the future. Of course, the stock could always be redeemed however that would be a big win for investors given its dollar price. And our view was that among the three stocks, it is ABR.PF which has the greatest likelihood of redemption as its coupon was likely to step up well above the coupons of the other two stocks.
Systematic Income Preferreds Tool
This is what the same picture looks like now. We see that the yield give-up for ABR.PF holders is now significantly higher. And while the stripped yield gap will naturally widen over time as the greater future yield pickup approaches, this move looks a bit excessive to us.
Systematic Income Preferreds Tool
In short, the choice of ABR.PF is now less obvious for two reasons. One is the much greater yield give-up today relative to the other stocks. And two, its price of 8% above the other two preferreds leaves less yield-to-call upside. Overall, it's not an unreasonable allocation but it's no longer the slam dunk that it was last March.
Stance And Takeaways
The key takeaway here is that ABR preferreds were very attractive assets at the end of Q1 because of an unusual pricing dislocation. This dislocation pushed the normally tighter spread preferreds to trade even with the broader sector.
The thesis for the original allocation was that ABR preferreds were significantly higher-quality securities than the average mREIT preferred due to factors like very resilient book value, internal business diversification and a high velocity of capital in the business. At the same time, they offered valuation on par with the rest of the mREIT sector, translating into a very attractive risk/reward.
Four months since, the picture has reverted to a more normal environment. The ABR preferreds have outperformed the sector and have become relatively expensive. At the same time the business environment for ABR has worsened with a sharp rise in non-performing loans. Management have also confirmed that they expect business to get worse before it gets better. Given this picture, we would look to take the gains and pare our allocation to ABR.PF on a further rally in the preferreds.
For further details see:
Arbor Realty Trust: Checking In On The High-Flying Preferreds