2023-04-07 08:41:15 ET
Summary
- ABR preferreds recently underperformed in the mortgage REIT sector, which provides a nice entry in our view.
- The company's relatively capital-light business model, low payout ratio, relatively low reliance on recourse debt and resilient book value are all attractive factors.
- We discuss the three stocks in the ABR preferreds suite and highlight why we like ABR.PF.
This article was first released to Systematic Income subscribers and free trials on Mar. 29.
In this article we discuss the Arbor Realty Trust (ABR) in the context of its three preferreds. In our view, the company's relatively capital light business model, low payout ratio, relatively low reliance on recourse debt and resilient book value makes its preferreds attractive income options. We also discuss why we have allocated to the 9.3% yielding Series F (ABR.PF) within the suite.
Business Strategy Recap
The company's business strategy is relatively unusual for the mortgage REIT space. 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 which is contributing around $90m a year (from just $4.2m in 2021) given the high level of short-term rates.
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.
Key Aspects For Preferreds Holders
There are a number of aspects of the company's strategy that are particularly attractive for preferreds shareholders.
The company operates primarily in the multifamily part of the lending space - an area that has typically been relatively resilient. Multifamily tends to be less cyclical than other parts of the mortgage space such as lodging, retail or office sectors. This is because of the traditional stabilizers such as unemployment insurance as well as explicit fiscal support for households like the one we saw in 2020.
Two, the company's borrowing profile is fairly resilient. Close to 70% of its secured debt is in non-recourse / non mark-to-market / long-dated CLO format. This creates less pressure for the company in case of falls in asset valuations. During the GFC about 76% of its borrowings were in the same format and the company sailed through fine without encountering margin call issues.
The company's recent first Freddie Q Series securitization further reduced its reliance on repo and credit facilities which make up around $3.5bn out of which around $2.5bn have margin call provisions. ARB is not the only mREIT with a relatively low footprint of non-recourse / non margin-call borrowings but it's an attractive feature and one that can limit the extent to which the company will burn equity by dumping assets in a fire sale in order to deleverage.
Three, ABR maintains a very low payout ratio of around 70%. This is in contrast to other mREITs whose payout ratios are closer to 100%. Although such a low payout ratio may be frustrating to common shareholders, it's a strong positive for preferreds shareholders as it allows the company to organically grow book value and increase its equity / preferred coverage ratio.
The company maintained a high level of cash and liquidity of around $800m at the end of the year. This can be a drag on returns for common shareholders however it's a nice cushion in case markets move through an air pocket. Obviously, it's not guaranteed to stay there, however management sounded worried about a "challenging recession" and wanted to be relatively liquid over the medium term.
Finally, and most importantly, ABR has a very resilient book value profile. A lot of this is due to its capital light business profile as highlighted above which allows the company to generate net income without having to carry a large amount of market-sensitive assets. This is a great result for preferreds holders who are very sensitive to sudden collapses in book value which leads to a thinner equity coverage cushion.
The chart below shows that ABR book value since Dec-2019 is up in contrast to the broader sector which has struggled through the 2020 COVID period as well as the 2022 rate rise period, both of which shaved off large chunks of book value.
Systematic Income
Valuation
From an outright yield perspective ABR preferreds are in the bottom half of the hybrid mREIT preferreds sector. The chart below sorts the sector by yield-to-worst (in effect, stripped yield given stripped prices are well below "par" which renders yield-to-call less relevant). Orange bars are what we call long-term reset yield which is the stripped yield at the consensus terminal rate forward rates which are around 3% for Libor / SOFR. These correspond to the longer-term yields of the Fix/Float stocks if they are not redeemed and should be taken into account.
Despite their relatively low yields today in the hybrid mREIT preferreds sector, what makes ABR preferreds fairly compelling as an entry point is the fact they have underperformed the sector recently. The chart below shows that their credit spreads (blue line), which used to trade much tighter than the hybrid mREIT preferred sector average (orange line), have nearly converged with the sector.
Systematic Income
The chart below shows the same story from a different perspective. It lists how much the sector preferreds have fallen from their respective 1-year high. Here, we see that ABR preferreds have taken some of the largest falls.
Arguably, some of this was due simply to the fact that the suite was fairly expensive. Another could be due to a recently issued report . While the report cannot be fully verified, many of the points are either uninformed or overly dramatic. For example, near the very top of the summary it reads "in an Archegos-like situation $2.5 billion of repo facilities are subject to margin call provisions".
Investors may recall that Archegos was a hedge fund that blew up on a highly leveraged equity bet (which, arguably, eventually took down Credit Suisse also). And while technically Archegos used equity total return swaps and not repo, the economic structure is the same.
Apparently what makes ABR repo so dangerous according to the report is that it is large and it has margin call provisions. The reality is that most, if not all, mortgage REITs and BDCs as well as the majority of CEFs have repo (or their cousin credit facilities) in large sizes and with margin call provisions. Repo by design has margin call provisions in order to protect the lender against loss of the lent cash. None of these features makes it an "Archegos" style situation in any way. And the fact that ABR faced no serious difficulties over Q1-2020 (when many mREITs suspended collateral posting or reached standstill agreements with creditors) should give investors some confidence in its borrowing profile.
Allocating Within the Suite
The ABR preferreds suite has 3 public preferreds outstanding, two fixed-rate stocks ABR.PE and ABR.PD and a SOFR Fix/Float 2026 Series F. E and F are trading near each other in yield terms of 9.8% and 9.6% respectively while F trades at a lower 9.3% yield which is then expected to step up significantly on its first call date in 2026, unless redeemed.
An unusual feature of ABR.PF is its interest rate floor on the floating rate at 6.125%. In effect this means that SOFR is floored at 0.683% in case it goes below that rate after its first call date.
Systematic Income Preferreds Tool
This is what the forward yield profile of the suite looks like.
Systematic Income Preferreds Tool
As usual we see a very typical and fairly rational pricing in the suite. The Fix/Float ABR.PF starts off with the lowest yield of the suite and is then expected to move to a higher yield. At the time of the stock's first call date, SOFR is expected to be around 3% which translates into a stripped yield of around 12.7%. This is clearly more appealing than the 9.5-9.8% stripped yields of its sister preferreds however it does require a 3.5 year wait and it's obviously not guaranteed as short-term rates could easily be below their consensus forecast by that time.
The stock could also be redeemed if ABR wish though, as we discussed a number of times, floating-rate preferreds are not automatically redeemed when short-term rates rise. For example, AGNCN and NLY.PF continue to trade happily despite boasting double-digit yields. What matters more than the yield of the preferred in question is what yield can the company achieve on its investments and what does it want its leverage to look like. Redeeming a preferred with cash would normally require the company to sell its assets, leading to an overall drop in net income. And refinancing a preferred with debt would raise its leverage, not something all mREITs want to do. However, in any case a redemption would be a good result for the stock as its yield-to-call is around 19%.
Ultimately, we view ABR.PF as an attractive hold today however, we recognize that it does require leaving some yield on the table for several years. Our thought process is that a reasonable worst-case scenario for short-term rates is something around 1.5% which would translate into a yield of 10.35% on ABR.PF - a figure well above the 9.6-9.8% yields of the fixed-rate stocks.
A breakeven level of short-term rates where the yield of ABR.PF will be the same is that of the other two stocks is around 1%. The stock features an unusual floor of 6.125% on its floating rate, meaning its yield would be floored around 9.14% if SOFR moves below 0.68% - an unlikely proposition but worth having in the back pocket.
A base case scenario of 3% short-term rates puts its yield advantage over the other 2 stocks closer to 3%. The best case scenario is a redemption which provides a yield of around 19%. In our view, ABR.PF is more likely to be redeemed than its two counterparts given the asymmetry in forward yields.
Despite its attractive relative yield profile, it's worth keeping in mind that because ABR.PF has a lower duration than its two counterparts, it could underperform if rates move lower. On balance, however, it is our pick in the suite.
For further details see:
Arbor Realty Trust: Picking Up The 9.3%-Yielding Preferred On The Drop