Elzeneys
Investment Thesis
Arbor Realty Trust's (NYSE:ABR) portfolio is showing signs of weakness according to its latest 10-Q report, with management anticipating further difficulties before a possible recovery. Recent news that the Department of Justice and FBI are investigating ABR for allegedly misrepresenting its financial position suggests that there may be hidden delinquent assets beyond the significant amounts already reported on the balance sheet. Given these risks, it may be wise to consider adopting a defensive strategy.
Hold: ABR's preferred stock, which offers some protection in case of further deterioration. Sell: ABR's common stock, as the downside potential seems to outweigh the remaining upside potential.
Today's stock price decline is just the beginning, and things could get significantly worse. Medical Properties Trust (MPW) is a cautionary tale. What MPW management downplayed as a temporary and insignificant issue escalated into a full-blown crisis. It would also be wise not to jump to conclusions regarding the DOJ/FBI investigation, and not to take ABR management's claims at face value. In its most recent quarterly filing with the SEC, management estimates a deteriorating financial condition and elevated credit risk.
The best-case scenario is that the Justice Department's investigation will force ABR to adopt more conservative rating and reporting methodologies, uncovering further challenges. The worst-case scenario is that it will face significant fines and lose its relationships with government-sponsored enterprises (GSEs) such as the Federal National Mortgage Association (OTCQB:FNMA) and the Federal Home Loan Mortgage Corporation (OTCQB:FMCC). ABR generates ongoing revenue with these GSEs from servicing GSE-backed loans.
New investors employing a “buy low” strategy may want to consider approaching ABR's common stock with caution. In our view, ABR's preferred shares, Series D (NYSE:ABR.PR.D), Series E (NYSE:ABR.PR.E), and Series F (NYSE:ABR.PR.F), are the best options to benefit from the current offering. Meanwhile, current holders of ABR's common stock must decide whether to exit to protect their capital against future downturns, or hold on to their holdings in hopes of a recovery.
Allowance for credit losses
ABR's reported credit risk has been growing rapidly over the past 12 months. Last quarter, the company reported a credit loss provision of $126 million, more than double the amount from the same period a year ago. A credit loss provision is an estimate of potential losses that management expects. In absolute terms, the $126 million figure is only a small portion (about 1%) of the company's $12.4 billion portfolio. But its rapid growth calls into question ABR's trajectory. Such erratic behavior is often a sign of broader portfolio problems. Secondly, it also reflects a decline in the value of collateral.
ABR provides bridge loans to real estate developers to carry out renovations to increase the value of properties and the associated rents. The amount of the loan depends on the borrower's projected future rental cash flows. Borrowers may be overestimating their returns, especially as an influx of new residential properties keeps rents down while interest rates and construction costs are rising.
Delinquent loans
ABR records a loan as delinquent when interest payments are 60 days late. As of Q1 2024, $465 million of the loan portfolio was delinquent. It is odd that the company has no loans that are between 60 and 90 days past due. One would expect a delinquency ladder, where different loans are recorded as delinquent on different dates. As shown below, this is not the case. All of the $465 million is more than 90 days past due, with zero delinquent assets that are 61 to 90 days past due.
This raises the question of how ABR reports credit risk. Borrowers are often required to maintain reserve balances for up to a year of loan payments. As interest rates rose, some of these borrowers struggled to make interest payments, and ABR may have tapped reserve balances instead of reporting delinquencies. Once those balances were depleted, ABR had no choice but to report delinquencies. Early last year, perhaps anticipating such developments, ABR said 2024 and 2025 would be tough years for ABR.
In its latest quarterly filing with the SEC, ABR noted that $490 million and $956 million of loans were 60 days or less delinquent as of March 2024 and December 2023. The company said the decline in these delinquent loans was due to $175 million progressing into the 60-days-plus category and $712 million being amended through interest forbearance and restructuring.
In the first quarter of 2024 alone, ABR modified $1.7 billion in loans. The modifications included lowering interest rates in exchange for borrowers investing additional capital, and the funds were used to:
Repaying the principal balance and/or increasing the interest reserve and/or paying accrued interest (which will bring the past due balance back into current status)
In most cases, the companies deferred interest payments until the debt was paid off, lowering interest rates, so the weighted average interest income rate on these loans is just 6.95%, well below the average of 9.45%.
Risk Scale
A more accurate measure of ABR's credit risk may be an asset class risk rating system that classifies loans into five categories.
Pass Pass/Caution Below Standard Suspicious
Management estimates that 49.5% of the portfolio is in need of special attention, substandard or questionable condition.These figures, along with the large loan modifications in recent months, paint a bleak picture of ABR's credit risk profile.
evaluation
At the height of the pandemic, bonds were trading at deep discounts due to lack of liquidity and general macroeconomic conditions. If ABR had wanted to sell the portfolio at that time, it would have done so at these discounts. However, ABR made little change to the valuation of the portfolio. These trends reflect one of the risks of investing in “investment fund companies” with illiquid assets whose management has broad discretion in estimating valuation.
According to Bloomberg, the Department of Justice and the FBI are pursuing leads that ABR misreported its assets. Earlier last month, reports emerged that the company was using off-balance sheet transactions to inject cash into some borrowers, influencing delinquency forecasts and artificially inflating earnings. Management responded by saying the reason they had not reported or discussed the matter was because they intended to do so in the second quarter of 2024.
Today's decline puts ABR's valuation at the low end of the industry range, but it's far from undervalued given the company's challenges.
Data by YCharts
Final thoughts and why we might be wrong
ABR receives some relief from continued revenue from government-sponsored lenders such as Freddie Mac and Fannie Mae, but those benefits pale in comparison to the size of the company's troubled portfolio.
As a REIT, the company distributes at least 90% of its taxable income to shareholders. This limits its ability to retain operating cash flow to maintain its net asset value (NAV) after capital losses. At this time, the company's aggressive and possibly lax accounting methods have allowed ABR to avoid impairments. However, if impairments were to occur, it would be difficult to recoup those losses using operating cash flow. It has taken ABR years to recover its NAV/share since the 2016 drop, it has never recovered its 2009 losses, and historically NAV recoveries have been slow and painful. Keep in mind that capital losses do not offset the 90% distribution requirement of ordinary income and vice versa.
Data by YCharts
The company's valuation, even after today's share price decline, is not “undervalued” given the risks. Therefore, it would be dangerous to expect a quick recovery in the company's common stock. It would be wise to wait until the dust settles and the full extent of ABR's challenges becomes clearer before considering investing in the company's common stock.
A more cautious approach to take advantage of the recent price decline would be to consider ABR's preferred stocks, Series F, Series D, and Series E. These instruments offer higher yields of 8.3% to 9.3% and have distribution priority over ABR's common stock, providing some protection.