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I Underestimated The Strength Of Arbor Realty

About: Arbor Realty Trust, Inc. (ABR)
by: Crunching Numbers
Crunching Numbers
Long only, dividend investing, media, telecom

Arbor has solid Q3.

Increases dividend to $0.30.

Sixth dividend increase since the end of 2017.

Let's be clear. I like Arbor Realty (ABR) a lot as a dividend income stock, even though I made my first purchases way too soon. When I paid $16.52 a share a dozen years ago, I saw the $2.48 annual dividend and did a quick calculation - in less than 7 years, the dividends would pay for the purchase! And, by reinvesting dividends, the compounding would help ease me into retirement. Everything went well for a year, but after the fourth dividend at the initial quarterly rate of $0.62, it was slashed to $0.24, and even worse, that was the last quarterly dividend until a $0.075 payment in May of 2012.

This was followed by consecutive quarterly raises to 10, 11, and 12 cents. After one more quarter at 12, it was increased to 13 cents for the next seven quarters before being increased to 15 cents in May of 2015. After five payment at 15 cents, the increases became more frequent. Two payments of 16 cents were followed by one of 17, two at 18, and sequential increases to 19, 21, and 25. After two quarters at 25, it was increased to 27 cents in November of last year.

In order to maintain its status as a REIT, Arbor must meet certain IRS guidelines. This is probably the reason that a special dividend was declared last December, when it announced:

.... that its Board of Directors has declared a special dividend of $0.15 per share of common stock. The special dividend will be paid in a combination of cash and shares of the Company's common stock on January 31, 2019 to common stockholders of record on December 28, 2018.

Stockholders may elect to receive payment of the dividend all in cash or all in common shares. The Company intends to pay up to 20% of the special dividend in cash (excluding cash that will be paid in lieu of fractional shares), with the balance of the special dividend paid in shares of the Company's common stock. To the extent that the total amount of cash elected by stockholders exceeds 20%, then the available cash will be prorated among those stockholders that elected to receive their dividend in cash, with such stockholders receiving the balance of the dividend in shares of the Company's common stock.

(Since I was still reinvesting all of the dividends, it didn't matter whether I received cash or shares.) This year, the company paid one more quarter at $0.27, to be followed by consecutive quarterly increases to $0.28, $0.29, and $0.30. However, even at $0.30, it's still less than half the rate it was back in 2007. Why the history? To discuss some interesting points for the long-term investors (like me) that did nothing but reinvest the dividends.

As I write this article after the close of the market on Thursday, November 7th, the shares were up $0.65 (or 4.37%) to close at $15.53. While that's still almost a dollar less than my original purchase price, this small initial position that was purchased in 2007 had a total increase of ~127% when the reinvested dividends are included. It hasn't been my best investment, but the compounded annual rate of return still comes to just under 6.9% (using monthly compounding), despite the dividend cuts and years without any payments or increases.

And since I made that initial purchase at $16.52 when the price fell close to $10 by August of 2008, I saw a "bargain" and added another 1,000 shares. That position, counting the reinvested dividends, has tripled in value. Several purchases were also made after the dividends were resumed, and the recent run-up in the price has led to my selling off some of the shares as the position is now quite a bit higher than my targeted allocations.

For instance, in a Roth IRA account that I manage for one of my daughters, Arbor had grown to more than 15% of her assets. Thursday, I sold nearly one-third of her position, but it's still fairly high and I will stop reinvesting the dividends. In some other retirement accounts, I have already stopped reinvesting the dividends.

How Could I be So Wrong?

The title of this article is about making a mistake. Clearly, I invested way too soon in Arbor, despite the positive results. I obviously failed to assess the real estate problems that would crater the economy. And, one could argue that trying to catch a falling knife - not once, but twice - was lunacy, despite the eventual outcome. Even on Thursday, as I watched the price of Arbor work its way higher right from the opening, I sold my daughter's shares way too early in the morning.

These shortcomings are not what I am referencing. Instead, it is a reference to my recent article published on Seeking Alpha titled Arbor Realty: 9% Yield With Growing Dividends. That article was published less than 2 months ago, September 24th, and it was a follow-up to the first Arbor article I had written in December of last year.

In the first article, I gave Arbor a "Bullish" rating. That rating was based mostly on the growing dividend, an additional special dividend, and a yield of 9.4%. I also wrote:

Is there also an opportunity for capital appreciation? I think so, but a lot will depend on the Fed and the future of interest rates.

... I have also been pleased with the performance over the last few years and see the December 13th closing price of $11.52 as an attractive entry point. That puts the current yield at nearly 9.4%, excluding the special dividend and reason enough to remain long.

The September 24th article included the following:

Since that recommendation, the dividend increases and the improved earnings have pushed the share price up over $13, a gain of more than 15%. Is there still time to make some money with this stock?

and concluded with:

While I don't expect the next 10 months to see another 15% appreciation in the share price, total return over the next year could easily surpass that figure. Regardless, collecting the dividend income while waiting for the share price to rise isn't the worst place to park some funds.

Wow! Was I ever wrong! The closing share price of $15.53 is almost 19% higher than the $13.07 price at publication of that September article. And forget about a ten-month or one-year price target. That gain took place in six weeks.

Why the sharp moves higher?

The snide answer is because there were more buyers than sellers, but that just avoids addressing the underlying reasons. And, in this case, I believe there are a number of events that occurred recently that can be considered as contributing factors.

Even before the company released its Q3 results on November 1, it had announced that it had closed on a private placement of 4.75% Senior Unsecured Notes in mid-October. The strong demand for the notes enabled the company to borrow more than the $100 million originally announced. On the earnings call, company management discussed the transaction:

...we elected to raise $120 million of fresh capital in October through a 4.75 unsecured debt issuance that was 100 basis points tighter than our last debt issuance in March.

This was very attractive capital as it'll be used to fund our pipeline of new investments and be immediately accretive to our core earnings. We continue to have tremendous success through our securitization expertise and our strong banking relationships in substantially reducing our debt costs, which has allowed us to achieve significant economies of scale and maintain our margin in a very competitive market. And again, the income generated from our balance sheet loan book is a significant component of our earnings, and we remain very confident in our ability to continue to growth this income stream.

How confident is the company in its ability to put funds to use? Confident enough to raise the dividend. Along with the Q3 release of earnings, the company announced an increase in the quarterly dividend from $0.29 to $0.30. It was the third consecutive quarterly increase and the sixth increase in the past two years. On the conference call the discussion around the dividend included the following comments:

...the significant growth we experienced this year continues to increase our run rate of core earnings, making us very confident in our ability to comfortably maintain our current dividend as well as grow it in the future.

.. the quality and diversity of our income streams along with the consistency of our earnings and our low dividend payout ratio, clearly differentiates us, which is why we believe we should consistently trade at a lower dividend yield and a substantial premium to our peer group.

When questioned about whether the dividend should have been increased, the response was:

... Well, number one, we feel we are very conservative. We have a lot of room within our dividend. And our core earnings just continues to grow at tremendous levels. And I think what's worth noting is when our earnings grows our baseline grows, it doesn't go down. Our servicing revenues, our escrow balances, our balance sheet, it shows a tremendous baseline from the year-to-year. And we have that -- we're still at a very low payout ratio. We feel there is a lot of room and we are very comfortable with it. And it would almost be inappropriate for us to have a lower payout ratio with our core earnings growing at such a rapid rate.

Equity investors also had positive news out of the Federal Reserve Board on October 30th, which announced a quarter-point cut in the Fed funds rate for the third consecutive meeting. While several news sources wrote that a number of economists feel the Fed will refrain from further cuts, Chairman Powell noted the Fed would respond to "any development that causes a material reassessment of our outlook."

Since October 24th we have seen 10 consecutive daily increases in the closing price of the stock These increases of 4, 14, 4, 4, 4, 43, 7, 16, 56 and 65 cents per share, or a total of $2.17 (or 16.24%), took the share price from $13.36 to $15.53. And, while the jump of $0.43 on November 1st can be directly attributed to the Q3 earnings, it is somewhat less clear as to what propelled the additional $1.44 move higher.

I have no idea if that additional move was a delayed follow-through after earnings, part of a general market rally, caused by a pair of press releases on November 5th and 6th that discussed an offering of more than $200 million of 4.75% convertible senior notes due 2022, some technical analysis triggering a buy signal, or a combination of all of these, or even something totally unrelated.

What's next?

Since I badly underestimated the recent move higher, I'm probably the wrong person to ask. On the positive side, I believe Arbor will demonstrate continued growth over the next year. And that growth will result in increased dividend payouts in order for Arbor to retain REIT status.

I also see a dividend, that despite the three increases in the past year, now yields 7.7%, down from nearly 9.4% when I first recommended purchasing the shares just over 11 months ago. I believe the share price may have moved too far and too fast, but I have often seen momentum take stocks beyond levels that I think are reasonable.

As noted previously, I recently sold some of our Arbor shares and I have stopped reinvesting dividends in some of our IRA accounts. Clearly, Arbor has been a strong performer for me, especially since I made some major additional purchases 4-6 years ago when the price was between $6 and $7. However, those timely purchases, along with dividend reinvestments and the sharp move higher over the past two weeks, and the even larger move over the past year, has thrown my portfolio out of balance. As a result, I will reluctantly be selling a bit more of my holdings.

For those that are looking for a steady dividend income stream and would be satisfied with a slowly rising dividend, Arbor certainly deserves consideration. However, I also think those investors that are more interested in significant near term capital appreciation could be disappointed.

Disclosure: I am/we are long ABR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As noted in the article, I could be selling a portion of my Arbor holding at any time in order to bring my asset allocation back into balance.