Arbor Realty Trust (ABR) is generally considered to be a commercial mortgage REIT in that the bulk of its assets are mortgages on commercial properties. Like many commercial mortgage REITs, it also owns some real estate but it is not primarily an equity REIT because commercial mortgages are the overwhelming majority of its asset base. I believe that ABR is an attractive investment now primarily because of valuation. In addition, it pays a very attractive yield and has attracted substantial insider buying. Finally, I think that management has evidenced both the will and the ability to enhance shareholder value. At Monday's closing price of $5.08 a share, it is a very attractive investment.
Before going into detail concerning ABR, it is helpful to review a few key considerations with respect to commercial mortgage REITs. I have written before about this group of stocks and I have pointed out that the financial statements are complex and potentially misleading. These companies generally utilize special purpose entities (usually CLOs and CDOs). In very general terms, these entities own as assets a pool of debt instruments and are, in turn, obligated to make payments to various tranches of investors. The commercial mortgage REIT typically manages the entity for a fee and owns the most junior or subordinated tranche or tranches. The obligations to pay the more senior tranches are generally obligations only of the special purpose entity and are non-recourse to the commercial mortgage REIT. However, for accounting purposes, the entire balance sheet of the special purpose entity is consolidated with the balance sheet of the commercial mortgage REIT creating the misleading impression that the commercial mortgage REIT is exposed to borrowings on a massive scale. In reality, most of that debt is non-recourse.
The above factor, the inherent volatility of owning the most leveraged position in the special purpose entities, and the general instability of the commercial real estate market put commercial mortgage REITs through a vicious shake out during the Panic of 2008. ABR was once a stock which traded in the 20s. Some entities in this group went through bankruptcy. I started investing in the debt of iStar (SFI) in 2009 and did very well and then invested in Northstar (NRF), Capital Trust (CT), and some other names in the group. The equity investments have been a roller coaster ride but I have generally done very well.
ABR pays a dividend recently increased to 11 cents a quarter which produces a yield of 8.7%. It completed a secondary offering in October which priced at $5.80 a share and so a buyer at this level is getting a significant discount to the offering price. There has been significant insider buying with the CEO buying some 160,000 shares in the last 6 months (as recently as mid-November) at prices near the current price.
In the most recent conference call, the company went through an analysis of its net asset value and explained why a value of $10.54 a share was the most accurate economic measure of that value (taking the secondary offering into account). I would have appreciated a more detailed analysis of the elements of that valuation. Essentially, ABR is valuing its positions in its CLOs and CDOs at some $250 million, valuing REO at gross $127 million subject to $54 million in debt, and adding cash and unlevered assets at $182 million. This is generally consistent with ABR's financial reports but a little more depth of analysis would have been helpful. The valuation is based on asset valuation as of the end of the last quarter but share count including the October offering of shares at $5.80. Commercial mortgage REIT balance sheets are like West Virginia roads - complex and confusing. In this case, I think the numbers are reasonable and, of course, the enormous discount of market price to NAV creates some margin for error. A diligent investor should go through the financial report and conference call transcript for himself.
The company seems to have managed through its pre-Crash legacy asset problems better than most commercial mortgage REITs. The evidence of this is that its pre-existing CLOs are all generating cash flow for the subordinate tranches it holds. ABR has some non-performing loans and has taken some write-offs but appears to have contained losses to levels which has permitted CLO cash flow to continue to flow to subordinated tranches. This could be the case only if the debt instruments that make up the CLO were performing relatively well. Many, many CLOs sponsored by commercial mortgage REITS prior to the Crash are still struggling and are not producing cash flow for the subordinated tranches. A tremendous amount of bad paper was put out there and ABR seems to have dodged the most lethal bullets.
ABR also recently completed a new CLO on attractive terms, the most important of which is that the CLO debt is non-recourse. ABR claims that it is the first non-recourse commercial REIT CLO since the Crash and, although I have not scoured the records of the entire industry, it is certainly the first one I am aware of. The non-recourse provision is important because it keeps risk off the ABR balance sheet. The fact that it was completed on a non-recourse basis also indicates that the outside investors in the senior tranches of the CLO had confidence in the quality of the assets which ABR put in the CLO and this, in turn, confirms that ABR is in the process of generating sound assets in the post-Crash marketplace. The CLO also frees up liquidity to be redeployed in new investments.
The commercial mortgage REIT sector is inherently risky and there is no doubt that this stock will bounce around in a risk-on, risk-off swinging market. There is also no doubt that this group will take a big hit if we get into a deep recession as commercial real estate comes under pressure. But, on balance, at 48% of net asset value and yielding 8.7%, with management buying back shares and at a discount to a recent secondary offering, ABR at $5.08 offers much, much more upside than downside.