Arbor Realty Trust (ABR): Upgrading to a BUY as Housing Market Prospects Improve
Introduction
Arbor Realty Trust (NYSE: ABR) is a unique type of mortgage REIT (mREIT) that specializes in providing short-term, rehab-oriented bridge loans to multifamily borrowers. These loans typically have an average term of 13 months and accrue higher interest rates (8.5-9%) due to their higher risk profile compared to traditional mortgages. Arbor’s business model involves earning the spread between the interest charged on these loans and its cost of capital, which is primarily funded through collateralized debt obligations (CLOs) and repurchase facilities. To further enhance its revenue stream, Arbor operates an Agency Business, which involves packaging and selling these bridge loans to other institutions while continuing to manage them on their behalf for an average fee of 0.4%. This allows Arbor to recapture a majority of its initial capital and earn a stream of long-term cash flows with an average remaining life of 8 years.
Risks and Challenges
Arbor’s business model is heavily influenced by the health of the housing market and interest rates. Multifamily borrowers are more likely to invest in rehab projects and take on debt when economic prospects are positive. Conversely, in times of economic downturn, borrowers may face difficulties in repaying their loans, leading to potential defaults. Additionally, as a leveraged mREIT with a tight spread on its loans, Arbor is sensitive to fluctuations in interest rates. Higher interest rates can increase the cost of funding its loans, putting pressure on its profitability.
Reasons for Optimism
Despite the risks associated with Arbor’s business, there are several reasons to be optimistic about its future prospects. The supply of new apartments, particularly in coastal markets, is currently at historically low levels. While demand for multifamily housing remains strong, supply is expected to remain constrained post-2025, especially in the Sunbelt region. Additionally, declining inflation, driven by factors such as easing shelter and auto insurance costs, suggests that the end of the current high inflationary environment may be approaching. This could lead to a more accommodative stance from the Federal Reserve and potentially lower interest rates in the future.
Valuation and Dividend Yield
Arbor Realty Trust currently trades at a price-to-book ratio of 0.96x, below the critical 1.0x threshold. Taking into account the additional value generated by its Agency Business, which we conservatively estimate at $400 million, adds an estimated $2 per share to Arbor’s fair value. Combined with its book value of $13.10 per share, we arrive at a fair value target of approximately $15 per share, representing a potential upside of 20% from its current market price. Furthermore, Arbor offers a high dividend yield of 13.6%, which is well-covered by its distributable earnings, providing investors with a compelling income stream.
Conclusion
While Arbor Realty Trust operates in a complex and cyclical industry, its unique business model and strong Agency Business position it well to benefit from improving housing market conditions. Taking into account the current market dynamics, valuation, and dividend yield, we upgrade our rating on ABR to a BUY. We believe that the stock is currently undervalued with significant upside potential and offers investors the opportunity to capitalize on the expected recovery in the housing market.
