Arbor Realty: Upgrade To A Buy Based On Bottoming Housing Market

seekingalpha04-23

Arbor Realty Trust is a unique mortgage REIT that provides short-term rehab-oriented bridge loans to multifamily borrowers.The company's business model includes a structured business segment and an ...

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This is a unique business model, quite frankly second to none, but it is also one that's quite complex and somewhat opaque. As a result, there have been several short attacks on Arbor, most notably by Viceroy Research, focused on distressed loans, overstated collateral and ultimately likely loan defaults. As a result, the stock has sold off, though not significantly, and short interest has been high and currently stands at 40%. Data by YCharts I've covered Arbor before, gave an introduction to their business model, and issued a HOLD rating at $15.80 per share. I liked the business model and saw the arguments made by short sellers as largely unfounded. But at the same time, I recognized (and so did management) that their business is heavily reliant on a healthy housing market, which we simply didn't have at the time. The stock also wasn't particularly cheap as it traded at 1.16x book value, right in line with my fair value estimate, assuming bridge loan defaults of up to 5%. Being fairly valued, with no price upside, I passed on the buy opportunity despite a double-digit 11% dividend yield, which I saw as sustainable. Since my initial article, the stock has underperformed with an RoR of -13% compared to the S&P 500 (SPX) RoR of 4.7%. Recently, however, I've seen growing evidence suggesting that housing market activity might improve and as a result, I've decided to upgrade Arbor to a BUY here at $12.60 per share. SA Recap of ABR's business Arbor's business model can be separated into two segments that beautifully complement each other. First, the REIT holds a $14 Billion portfolio of mainly multifamily bridge loans and earns the spread between the interest that they charge and their cost of capital in what they call Structured Business. These are mostly short-term loans with an average term of only 13 months and because they are riskier than traditional mortgages they accrue higher interest of about 8.5-9%. The Structured Business accounts for 60% of total revenues and is very sensitive to housing market dynamics. 2023 ABR annual report To fund its loans, Arbor relies heavily on collateralized debt obligations (CLOs) and repurchases facilities which accrue interest at an average rate of 7.15% which are long-dated and non-recourse. Arbor pockets the difference between the interest it charges on its bridge loans and the interest it pays on these liabilities. Currently, the net interest spread stands around 1.7%. Because the spread is quite tight and because the REIT is quite heavily leveraged (5.2x calculated in my last article), it is very sensitive to interest rate fluctuations. 2023 Arbor annual report Second, Arbor runs an Agency Business which packages these loans, off-loads them to other institutions and importantly continues to manage these loans on behalf of those institutions for an average fee of 0.4%. This allows Arbor to (1) recapture the majority of their initial capital which can be reinvested and (2) earn a stream of long-term cash flows with an average remaining life of these originations of 8 years. And since the overwhelming majority of loans are off-loaded to Fannie Mae (69%) and Freddie Mac (17%), this cash flow is highly visible. 2023 ABR annual report Risks Having discussed the business model, it should be clear that Arbor faces two key risks that stem from its sensitivity to the housing market and interest rates. Multifamily borrowers are much more likely to want to invest into rehab projects when future prospects are positive. Similarly, when things get tough, borrowers are much more likely to default on existing loans. For this reason, the lending business is very sensitive to the health of the housing market, especially as it relates to rents, vacancies and property values. A housing market crash represents a major risk for Arbor, because it makes borrowers likely to default on their loans. Secondly, because the mREIT is leveraged and the spread it earns on its loans is relatively tight, it's prone to be very sensitive to interest rates. Therefore, a rise in interest rates or a prolonged period of high interest rates is a risk factor. Why the worst could be behind us Management stated in their Q3 and Q4 earnings calls that they expected the end of 2023 and the first half of 2024 to be the \"most challenging part of the cycle\" with \"elevated delinquencies\". This is not surprising, given that housing market has been very muted. But there are reasons to be positive about the future. Supply of new apartments is historically low in both Coastal markets and is expected to plummet post 2025 in the Sunbelt. Recently, I published an article on Camden Property Trust (CPT) where I argued that rents in the Sunbelt are likely to decline in 2024 and 2025, but grow rapidly in 2026 and beyond. And since the stock market tends to be forward looking, I wouldn't be surprised if apartment REITs bottom this year (depending on what happens with rates, of course). Rent dynamics in the Sunbelt are especially important for Arbor, which has 50% of its bridge loan portfolio invested in Texas, Florida and Georgia. Beyond rents, declining inflation is another reason to be optimistic. Sure, headline inflation remains sticky and has failed to decline below 3%. But as I have explained in detail in this article, the reason for this stickiness is shelter and auto insurance inflation, both of which have a significant lag. Excluding these two components, CPI would have already been at 1.1%, well below the Fed's 2% target. And it's not like we're cheating ourselves by excluding these. Data shows (see the article linked above) that property values and rents are down YoY and so are used car prices which are the sole driven of auto insurance prices. In an absence of a black swan event, I expect inflation to fall to 2% towards the end of the year and the Fed to cut rates (slightly) more aggressively that is currently implied by trading activity. CME Watch Tool Low supply in Coastal markets, rents likely to bottom in 2025, falling inflation and an accommodating Fed could very well mean that the bottom in housing market related stocks, incl. Arbor, is near or even behind us. Valuation Any kind of valuation of Arbor would not be complete without mentioning their high 13.6% dividend yield. The dividend has grown substantially over the past 10 years, with a 10%+ CAGR. Moreover, the $1.72 per share dividend is reasonably covered with $2.25 per share in distributable earnings. That's a payout ratio of 76%. In terms of valuation, ABR's price to book ratio has declined to 0.96x, below the critical 1.0x threshold. Last time, I argued that the REIT actually deserved to trade at a premium, because of its Agency business, which provides additional synergies and highly visible cash flow with little to no effort. Data by YCharts Arbor values the Agency business at $500 Million. To air on the side of caution, I value it at 2x revenue, which corresponds to roughly $400 Million and therefore (with 188 Million shares outstanding) adds about $2 per share to the fair value. Adding this to the book value of $13.10 yields a price target of roughly $15, up 20% from today. Bottom Line  Arbor runs a complex business model, but one that makes it superior to traditional mREITs. Taking into account the synergies that it derives from its Agency business, the REIT trades at a discounted valuation and has upside of about 20% to its fair value. Combined with a double-digit dividend yield, which is covered by distributable earnings, that's enough to upgrade the stock to a BUY. I feel especially good about this upgrade, because I expect housing market related stocks to bottom this year as rent growth is likely to resume post-2025 and as inflation seems destined to decline below 2% before the end of the year.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2429950193"}