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Arbor Realty Trust, Inc. (NYSE:ABR)

Q4 2011 Earnings Call

March 2, 2012 10:00 am ET

Executives

Paul Elenio – Chief Financial Officer

Ivan Kaufman – President and Chief Executive Officer

Analysts

Lee Cooperman – Omega Advisors

Operator

Good day, ladies and gentlemen and welcome to the fourth quarter 2011 Arbor Realty Trust earnings conference call. My name is Jeff and I will be your coordinator for today. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Paul Elenio, Chief Financial Officer. You have the floor, sir.

Paul Elenio

Thank you, Jeff. Good morning, everyone and welcome to the quarterly earnings call for Arbor Realty Trust. This morning we will discuss the results for the quarter and year ended December 31, 2011. With me on the call today is Ivan Kaufman, our President and Chief Executive Officer.

Before we begin, I need to inform you that statements made in this earnings call may be deemed forward-looking statements that are subject to risks and uncertainties, including information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. These statements are based on our beliefs, assumptions and expectations of our future performance, taking into account the information currently available to us. Factors that could cause actual results to differ materially from Arbor’s expectations in these forward-looking statements are detailed in our SEC reports.

Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today. Arbor undertakes no obligation to publicly update or revise these forward-looking statements to reflect events or circumstances after today or the occurrences of unanticipated events.

I’ll now turn the call over to Arbor’s President and CEO, Ivan Kaufman.

Ivan Kaufman

Thank you, Paul, and thanks to everyone for joining us on today’s call. Before Paul takes you through the financial results, I would like to reflect on how we closed the year, touching on some of the more significant accomplishments, and then turn my focus to our operating philosophy and outlook for 2012.

2011 was a tremendous year in that we were able to successfully complete our goal of returning fully to our core lending business, increasing the quality of our platform, net interest debts, core earnings, which has put us in a position to return to a dividend paying stock. Clearly, the steps we took in 2010 to transform our entire balance sheet, ridding ourselves of our short-term recourse legacy debt while retaining a substantial amount of our equity value and liquidity, were critical in paving the way for us to become an active participant again in commercial mortgage lending in 2011.

We have a very deep and versatile originations platform, both through our manager as well as the REIT, and we are extremely pleased with our ability to quickly ramp up our production once we felt it was the appropriate time to reenter the lending arena.

We also feel that this origination network will allow us to continue to grow our platform and take advantage of the opportunities in the market to diversity our revenue sources and produce significant core earnings going forward. In fact, in the fourth quarter, we originated 14 loans totaling approximately $103 million with a weighted average yield of approximately 7.8% and we finished 2011 with total originations of 30 loans totaling $206 million with a weighted average unleveraged yield of 7% and a weighted average leverage yield of approximately 17%.

As we discussed on our last call, we also diversified our investment platform by becoming active in the residential lending arena, which is an area we have a significant amount of experience in and we believe will generate outsized returns on our capital.

In the fourth quarter we purchased five residential mortgage securities totaling $31 million with an average yield of approximately 6%, and we closed out 2011 purchasing seven securities totaling $36 million. These securities have an expected average life of 18 to 24 months and are expected to generate levered returns in excess of 20%. At December 31, 2011, the balance of these securities was $30 million with a corresponding leverage of $25 million.

We have continued this momentum into the first quarter of 2012 originating seven loans totaling $40 million with a weighted average yield of approximately 7.7% and expected levered returns in excess of 15%, and purchasing four residential securities totaling $20 million with a weighted average yield of 6.2% and expected levered returns in excess of 20%.

Additionally, our pipeline remains strong and we’ll continue to deploy our capital into new investment opportunities with a targeted return of 15% on an unlevered or levered basis. As Paul will discuss in more detail later, this ramp up and diversification of production has increased our core earnings run rate going forward and we are pleased with the opportunities we are seeing in this market to build up our portfolio with high quality assets and continue to increase and diversify our core earnings in the future.

We also were extremely successful in recycling our capital in 2011 through a runoff and the monetization of our non-performing and unencumbered assets, which has increased our available liquidity to deploy into new investment opportunities. In the fourth quarter, we generated cash runoff of $102 million and a total of $216 million for 2011. Our cash position as of today is approximately $65 million, not including approximately $22 million of cash collateral posted against our swaps.

We also have around $90 million of net unencumbered assets, as well as $90 million of our CDO bonds that we purchased for $45 million, which could produce additional liquidity. These assets, combined with cash on hand and cash posted against our swaps, gives us approximately $220 million of value. This, in addition to approximately $235 million of value between the equity in our CDO vehicles and our real estate owned assets, for a total value of approximately $455 million.

We have been extremely effective in managing our CDO vehicles, receiving fall cash counts at a distribution to date and optimizing the utilization of these advantageous debt structures while maintaining sufficient cushion on all our tests. While there can be no assurances that our CDO vehicles will continue the cash flow in the future, we will remain focused on optimizing and managing these vehicles effectively.

We currently have three CDO vehicles in place, which, as of mid-January 2012, have passed their replenishment periods, and we have utilized all the cash in these vehicles. We do feel that based on the terms and quality of the assets in these vehicles, we will continue to receive the benefits of these non-recourse low cost financing facilities for several more years to come. In addition to our liquidity and portfolio runoff, we will continue to look for additional non-recourse financing facilities when available and utilize short term warehousing facilities when appropriate to fund our growth.

As previously disclosed, we were able to add a $15 million bridge loan financing facility in July 2011, which was fully utilized at December 31st. We feel that the performance of our CDOs, as well as the diversity of our platform, will give us a competitive advantage in accessing the debt and equity markets that we believe will become available in the future.

As we’ve discussed in the past, we’ve been very successful in repurchasing our debt at deep discounts and monetizing our equity kickers generating liquidity, recording significant gains, and retaining a substantial amount of our equity value. In the fourth quarter, we repurchased $5.6 million of our CDO debt for $2.6 million, recording a gain of approximately $3 million, which, combined with the gains in the first three quarters, totaled $10.9 million of gains from debt repurchases in 2011.

As of today, we own approximately $90 million of our original CDO bonds at a $55 million discount to par, which represents significant embedded cash flow that we may realize in the future periods. We will continue to evaluate the repurchase of our CDO debt going forward based on availability, pricing and liquidity.

Additionally, during the third quarter, we were also successful in monetizing one of our equity kickers, recording gains of approximately $3.6 million for 2011. As previously disclosed, we were very pleased to have completed the previously approved stock repurchase program that was announced last June, repurchasing all 1.5 million shares of our stock authorized under the plan at an average price of around $3.85.

We were also pleased that the Board approved a follow-on buyback plan for up to 500,000 shares in December, of which we purchased 170,000 shares to date at an average price of $4.02. Currently, with a book value of approximately $7 per share and an adjusted book value of around $11 per share, we believe this investment of our capital is extremely accretive to our shareholders.

Now I would like to update you on the credit status of our portfolio and discuss our views of the commercial real estate market. During the fourth quarter, we recorded $25 million of loan loss reserves and losses on the sale of an asset, as well as a $.7 million impairment on real estate owned asset. The fourth quarter loss was largely due to a $17 million reserve related to a previously impaired asset. On this particular loan, the additional reserve was recorded as a result of ramifications resulting from the special servicer on this asset.

After a two year long five-party negotiation with the borrower and special servicer, where we believed we had reached an understanding on a restructuring that would preserve the value of our position, we were recently informed there would be a change in special servicer, and as a result, all efforts related to the potential restructuring were no longer applicable. Based on this new information, management felt this asset could be further impaired, and therefore recorded an additional reserve during the fourth quarter.

We will continue to work exceedingly hard on restructuring this deal in order to potentially recover our investment. We also had some small recoveries of previously recorded reserves during the quarter of approximately $0.2 million in addition to $2.9 million of recoveries in the first three quarters and $18.1 million of recoveries generated in 2010 for total recoveries of approximately $21 million to date.

During the fourth quarter, we refinanced and modified $84 million of loans and extended $180 million of loans. At December 31st we had twelve non-performing loans with a UPB of approximately $58 million and a net carrying value of $15 million, which is up slightly from $14 million at September 30th. We believe we have done an outstanding job of modifying and restructuring a substantial amount of our portfolio, significantly improving the quality of our assets and predictability of our income stream.

Overall, the commercial real estate market recovery remains uneven, although we did see some improvement in 2011 and in 2010 so far, and there have been some signs of further stabilization and recovery in certain segments. We do feel that after our fourth quarter loss reserves, we have now put substantially all our legacy issues behind us.

Although it is always possible we could have some additional write-downs in our portfolio based on market conditions, as we look at our legacy book as of today, we feel that any potential losses will not be material and are optimistic that we could have recoveries and gains from debt repurchase in the future to offset any potential additional losses. However, the timing of any potential losses, recoveries and gains on a quarterly basis is not something we can predict or control.

In summary, we’re extremely pleased with our accomplishments in 2011, especially in our ability to once again become an active lender in the market and significantly diversify our revenue sources and increase our core earnings run rate. We are excited about the investment opportunities we are seeing in the overall macro stabilization that has begun in the commercial real estate sector.

We are confident that our deep originations network will continue to purchase high quality investment opportunities with attractive returns for us to grow our platform and increase our core earnings. We are quite pleased with the pipeline of new business and our continued ability to fund these opportunities by recycling our capital through runoff and monetization of unlevered assets and the continued use of available debt facilities.

Clearly, our primary focus will continue to be to invest our capital with the high yielding opportunities and appropriately leverage these investments with the goal of continuing to increase our net interest rates and core earnings, and based on this success and the opportunities we are seeing in the market, we feel confident that we’ll achieve our goal of return to a dividend in 2012. The amount and timing of this potential dividend will be determined over the next several months based on the future results, market conditions, and capital leads.

I will now turn the call over to Paul to take you through some of the financial results.

Paul Elenio

Thank you, Ivan. As noted in the press release, we had a net loss for the fourth quarter of $27.8 million, or $1.15 per share, and a net loss of $40.3 million, or $1.61 per share, for the year ended December 31st, 2011. For the fourth quarter, we had an FFO loss of $24.9 million, or $1.03 per share, and an FFO loss of $32.6 million, or $1.30 per share, for 2011.

We recorded $25.6 million in losses from our portfolio for the fourth quarter, consisting of loan loss reserve, losses from the sale of an asset, and impairment on an REO asset. We closed out the year with $48.9 in net losses from our portfolio for 2011, of which $52 million were made up of a combination of loan loss reserve, losses on restructured and sold loans, and impairments on REO assets, partially offset by $3.1 million in recoveries of previous reserves.

And after the fourth quarter reserves and charge offs of previously recorded reserves, we now have approximately $185 million of loan loss reserves on 24 loans with a UPB of around $285 million as of December 31st, 2011.

As Ivan mentioned earlier, we also continued to repurchase our debt at deep discounts and monetize our equity kickers during 2011, recording a $30 million gain from the repurchase of some of our CDO debt for the fourth quarter and a total of $10.9 million of gains for the year, as well as a $3.6 million gain from the monetization of one of our equity interests during 2011.

At December 31st our book value per share stands at $7.04 and our adjusted book value per share is $11.32, adding back deferred gains and temporary losses on our swaps. Additionally, as Ivan mentioned, we currently have approximately $65 million in cash on hand and $22 million of cash posted against our swaps. Between this cash, our REO assets, unencumbered assets, CDO bonds, and equity value in our CDOs, net of reserves as of December 31st, 2011, we currently have approximately $455 million of value.

Looking at the rest of the results for the quarter, the average balance in our core investments was relatively flat at around $1.6 billion for both third and fourth quarters. The yield for the fourth quarter on these core investments was around 4.69% compared to 4.61% for the third quarter. This increase in yield was primarily due to higher yields on our fourth quarter originations and security purchases, although we did not receive the full benefit of these investments in the fourth quarter due to originating the bulk of these loans late in the quarter.

More significantly, the weighted average all-in yield in our portfolio increased to around 4.82% at December 31st compared to around 4.60% at September 30th due to the full effect of the higher yields on our new production in the fourth quarter. The average balance on our debt facilities also remained relatively flat from last quarter at approximately $1.3 billion. The average cost of funds on our debt facility was approximately 3.44% for the fourth quarter compared to 3.51% for the third quarter.

Excluding the unusual impact on interest expense from our swaps for both the third and fourth quarters, our average cost of funds was approximately 3.56% for the fourth quarter compared to around 3.63% for the third quarter. This decrease was mainly due to the maturity of certain interest rate swaps in the fourth quarter.

Additionally, our estimated all-in debt cost was around 3.53% at December 31st compared to around 3.64% at September 30th. The overall normalized net interest spreads on our core assets increased by 15% to approximately 1.13% this quarter from approximately 0.98% last quarter, primarily due to increased yields on new originations.

And more significantly, our net interest spread run rate increased 34% to approximately 1.29%, or approximately $31 million annually at December 31st compared to approximately 0.96%, or approximately $27 million annually, at September 30th. This, again, was primarily due to the full effect of high yields in our fourth quarter production and we are optimistic we will be able to continue to grow this run rate based on the opportunities we are seeing in the market.

Additionally, as we mentioned on our last few calls, we have acquired some properties that were securing certain of our loans in the normal course of our lending operations. Property operating income related to our REO assets decreased approximately $2.4 million and property operating expenses also decreased approximately $400,000 from last quarter. This is largely due to the seasonal nature of income related to a portfolio of hotels we acquired in the first quarter.

As of December 31st we have two REO assets we are holding for investment totaling approximately $129 million subject to approximately $54 million of assumed debt for a net value of approximately $75 million. As of today, we believe these two assets should produce NOI before depreciation and other non-cash adjustments of approximately $3 million to $4 million on an annual basis, and this projected income, combined with our net interest spread run rate at December 31st, 2011 of approximately $31 million on our loan and investment portfolio, gives us approximately $34 million of estimated core FFO earnings before loan loss reserves and operating expenses as of December 31st, 2011.

Operating expenses did increase from the third to fourth quarter, largely due to increased employee and operating cost associated with our active origination platform and loan restructurings, combined with stock-based compensation issued to certain of our senior management team.

Next, our overall leverage ratios were up slightly to around 72% on our core lending assets and around 84% including the trust deferred as debt for the fourth quarter. This is compared to 70% and 81% respectfully in the third quarter and our overall leverage ratios on a spot basis were also up to 3.9 to 1 at December 31st from 3.5 to 1 at September 30th. This was due to the utilization of our new warehouse lending facility and leverage on our residential securities purchased during the fourth quarter, combined with a decrease in equity, primarily due to our loan loss reserves during the fourth quarter.

There are some changes in the balance sheet compared to last quarter that are worth noting. Restricted cash in our CDO vehicles increased approximately $32 million from last quarter to approximately $67 million at December 31st, 2011, largely due to fourth quarter runoff that was used to finance some of our unlevered assets and pay down CDO debt in January 2012, and we’ve now used all investible cash in these CDO vehicles.

The purchase agreements and credit facilities increased by approximately $61 million due the utilization of our new $50 million debt facility, combined with leverage on the residential mortgage securities we purchased during the quarter. In addition, other comprehensive losses decreased by about $5 million for the quarter. This was primarily due to an increase in the market value of interest rate swaps from a change in the outlook on interest rates.

GAAP requires us to flow the changes in value of certain of our interest rate swaps through our equity section, and Treasury stock increased $2.8 million from last quarter due to the repurchase of company stock in accordance with our stock buyback program.

And lastly, our portfolio statistics as of December 31st show that about 69% of the portfolio was variable rate loans and 31% are made up of fixed rate loans. By product type, about 62% was bridge, 19% junior participations, and 19% mezzanine and preferred equity investments. By asset class, 45% was multi-family, 33% was office, 9% hotel and 9% land. Our loan to value was around 84%, our weighted average median dollars outstanding was 55%, and geographically, we have around 37% of our portfolio concentrated in New York City.

That completes our prepared remarks for this morning and I’ll now turn it back to the operator to take any questions you may have at this time. Jeff?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from the line of Lee Cooperman with Omega Advisors. Please proceed.

Lee Cooperman – Omega Advisors

Thank you. Good morning and thanks for your comprehensive rundown. I was wondering if you could help me pull it all together, since you give a lot of individual numbers, and I think I got interrupted by someone in my office at a critical moment when you said something about the core FFO, but you mentioned a number, Paul, of $34 million of core FFO.

Is that what the run rate was from operations at the end of the year, or did I misinterpret it? These are my questions: The adjusted book is 1132, GAAP book 704. In the environment that we’re in, what is the reasonable return for you guys to justify your compensation on that book value? Is it 10%, 12%, 14% return on book type of business? If so, what’s the timetable to get there?

Second, if you can elaborate on that $34 million and the significance of it, and then my last question is if you could help me out on the dividend comment in your press release, you said on the restructured terms, the company junior subordinated notes, et cetera, et cetera. If you could kind of elaborate what’s behind that. What would you have to do to allow yourself to pay a cash dividend?

Paul Elenio

Sure. Hi, Lee. It’s Paul. So when we talk about our core earnings run rate, we’re looking at the financial statements as of December 31st, 2012. As we talked about in our commentary, we had a lot of high yielding originations we added at the end of the fourth quarter that we didn’t get the full effect for in the quarter, so looking forward and just looking at how that will affect the run rate going forward, we’re looking at our portfolio and we have about $1.6 billion earning assets earning about 4.82% going forward, and $1.3 billion of debt paying about [353].

That annualized is a $31 million net interest spread run rate on our loans, investments and securities going forward before we do anything else in 2012. You add in the REO properties that we’re estimating NOI of $3 million to $4 million, that gives me the $34 million to $35 million number we were mentioning on the call. If you lob in the operating expenses and assume operating expenses for this conversation stay flat year on year, that gives me around an $8 million core FFO run rate going forward before any normal reserves or anything of that nature.

That’s about, on our average shares outstanding today, that’s about just over $0.30, about $0.33 a share. Clearly, we’ve had a lot of positives happen in the fourth quarter. We’re very optimistic about what we’re seeing in the future. In fact, we did put on $40 million in new loans at a pretty high rate in the first quarter already and bought $20 million in securities, so we expect that number to grow.

Obviously, there are some things that we don’t control and market conditions and such, and assuming we don’t have any major hiccups coming out of our portfolio that we don’t anticipate, we expect that number to grow. How fast is will grow will depend on how quick we can put out the capital and what kind of returns we can get.

As far as the commentary in the press release around the dividend being constrained right now under the junior subordinated notes, as you may recall, we renegotiated our junior subordinated notes almost three years ago lowering the pay rate from a LIBOR-based pay rate to a flat 50 basis points. That expires at the end of April, so at the end of April, we will no longer be restricted under those junior subordinated notes because we’ll be going back to pay the regular rates that they were being paid, which is a LIBOR-based rate.

We will no longer be restricted from paying a cash dividend. The restriction was there just because we had gotten some relief on the interest payment rate for a three-year period, but once that expires, we’ll be paying them their current rate and will be able to pay a cash dividend.

I think I’ll let Ivan answer the question on what we think a reasonable return is going forward based on the business we’re seeing.

Ivan Kaufman

I think we have a significant pipeline, Lee, relative to the bridge loans we’re originating and being able to leverage them, and we consistently redeploy our capital on a levered basis in excess of 50%. I think there will be a period of time when we’ll be recycling some of the lower yielding loans in our portfolio and replacing them with higher yield and that’s just a process of time.

So we’re seeing periodic repayments or periodic extension of modifications, and different than what we saw coming out of the beginning of the recession where we had to lower rates, now we’re seeing, actually, our rates increase, so we’re seeing the opposite trend. So we’re pretty pleased with that development.

We see ourselves, also, originating an excess of what we originated last year, and originating at similar yields. We’ve done that successfully the first couple of months and we have a robust pipeline to continue that.

In addition, venturing into the RMBS business, the residential mortgage business, has given us another opportunity to enhance our yields, also, and as I noted in my comments, we focus mainly on short duration RMBS product and we’ve seen yields well in excess of 20%. So I think over the period of this 12 months, you’ll see our portfolio transition into high yielding opportunities and that $8 million of net income grow and grow on a quarterly basis.

And with respect to potential hiccups we may have, we also feel reasonably that there may be some hiccups. There are certain things outside of our control, but likewise, we also have just as much of a likelihood, in my view, that we could have recoveries and should have recoveries that should be able to match any hiccups we have given the environment and the transition in the environment.

So we’re pretty optimistic. We see a good level of growth rate. In addition, we also have the benefit of increasing our spreads over time by having some burn off on some old swaps that were in place, so I think embedded in our interest spreads growing is a schedule of burn offs that will occur over the next three years on a quarterly basis, but a lot of those burn offs becoming very active in 2013.

Lee Cooperman – Omega Advisors

It would seem, not to put words in your mouth, but listening to everything you have to say, it would not be unreasonable to assume this company should have FFO in two or three years of -- in excess of $1 a share.

Ivan Kaufman

You could draw those calculations. Clearly, there’s a lot of opportunity. We’ve taken over some real estate that were driven down to the ground, needed some CapEx and improvement, but it will see some significant growth within those assets that are on our books, and we’ll continue to take on the opportunity to try and get our hands on some other assets within our portfolio, so I think we have three sources to four sources of a lot of top line revenue growth.

I do want to also comment a little bit on our expense flows. In running and getting our originations up to speed, we’re very fortunate in being able to transition some of our people out of asset management who came from originations and put them back in originations, but we had some major loans that we restructured successfully in the fourth quarter and the third quarter, and as you know, restructuring loans requires an extraordinary effort.

And I think our compensation costs were perhaps high because we had a double situation going on in 2011, that of originating new loans and reestablishing that infrastructure, but more importantly, restructuring the balance of the loans in our legacy portfolio, which took an enormous effort and enormous expense, and we think the bulk of that, the majority of that is behind us and we should see a lot of that lumpy expense, although in many ways, it was not immediately revenue generating, will generate revenue in the future, but the expense of those -- that expense should be managed a lot more efficiently in the future.

Lee Cooperman – Omega Advisors

Thank you. Good luck and I appreciate the comments.

Ivan Kaufman

Thanks, Lee.

Operator

(Operator instructions) Ladies and gentlemen, that will conclude the question and answer portion for our call. I’d now like to turn the presentation over to management for closing remarks.

Ivan Kaufman

Thank you, everybody, for your participation. As you can see, this is clearly a transitional call for us and we’re very pleased to be in a position to deliver such positive news and into 2012 on a very optimistic -- we look forward to your participation on future calls. Thank you.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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