Arbor Realty Trust: Plenty of potential, if it survives

A couple years ago, I helped my wife build an income portfolio.

It consisted of 10 stocks from companies that:

1. Seem to have a long-running, stable business

2. Pay a dividend

One of those companies was Arbor Realty Trust (ticker: ABR).

Flash forward a couple years.

On July 12, 2024, news surfaced that the Department of Justice and the FBI were questioning ABR's financial reporting practices [1]. 😬

That night, I discussed the situation with my wife.

Given the goals of her portfolio, we ended up selling all her ABR shares at a small loss. 😢

Meanwhile, in my learning account, I bought Arbor Realty Trust Series F Preferred shares (ticker: ABR-PF).

There's a lot to go over here.

But, it should be pretty interesting.

First, what's a REIT?

ABR's a real estate investment trust (REIT).

As a REIT, the IRS requires ABR to [2, 3]:

• Have at least 75% of its assets in real estate, cash, or government bonds

• Have at least 75% of its gross income come from real estate-related transactions

• Pay at least 90% of its taxable income to shareholders through dividends

ABR's what's called a mortgage REIT.

A mortgage is a loan made to buy real estate. And a mortgage REIT is a REIT focused on mortgage loans.

ABR's business is to:

1. Loan money to businesses that want to buy real estate

2. Receive interest payments and service fees for those loans

3. Send the profits to shareholders as dividends

And, what're preferred shares?

Preferred shares are ownership units of a company, just like common shares.

But, preferred shares have different rights than common shares.

For example, preferred shares typically [4]:

• Have priority over common shares for any bankruptcy payouts

• Have priority over common shares for any dividend payments

• Don't have voting rights

The specifics vary from stock to stock.

To create new share types, companies have to file info about them with the Securities and Exchange Commission (SEC) via form 424B5.

The rights of any given share type can be found in its respective filing.

ABR currently has 3 types of preferred shares:

• 6.375% Series D

• 6.25% Series E

• 6.25% Series F

The ones we'll be discussing are the 6.25% Series F shares (ticker: ABR-PF).

So, what's the story?

From a high level, ABR looks like a reasonable investment for income purposes.

Here's a stock screener of mortgage REITs of similar size to ABR:

ABR's metrics give a good initial impression:

• It has a 12.84% dividend yield (the S&P 500's historical average total return is around 10-11% [5])

• Its price per earnings (P/E) and price per book (P/B) ratios (measures of how expensive a stock is) aren't far above or below those of its peers

• Its debt load is on the lower end among its peers

The P/B and P/E ratios are also within the company's own historic ranges:

For 20 years, the company's increased revenue:

Per-share profits have had some bumps along the way, but they've been reasonably steady:

So, things look pretty positive so far.

Then, the US Department of Justice gets involved

On July 12, 2024, it was announced that the Department of Justice and the FBI were requesting information about ABR's financial reporting practices [1].

This caused ABR's price dropped from $15.53 to $12.89:

That's a 17% drop in a single day: ($15.53 - $12.89) ÷ $15.53 = 0.169994 ~= 17%

Sabotage

Some companies make money by betting that a stock's price will fall.

Over the past year, several of these companies have been intentionally trying to make ABR's price fall.

A key player in this attack is a company called Viceroy Research.

For about 9 months, Viceroy has been publishing articles questioning ABR's asset management and reporting practices [6].

And, there's merit to some of the things they've called out.

For example, Viceroy's pointed out that ABR:

1. Is modifying the terms of failing loans, but not substantially reducing the risk of those loans

2. Has a large number of loans that're late on payments

3. Makes it difficult to determine how much accrued (unpaid) interest it's owed

4. Has loaned another company money to buy a foreclosed property it held

   1. This means the foreclosed property's no longer listed in ABR's assets, but ABR's still exposed to the risk

This clearly signals high risk.

That said, it doesn't look like ABR's doing anything illegal to me.

So, I expect that nothing will come of the DOJ inquiry.

But, then again, I'm not a lawyer. Just a dork with a computer.

At a minimum, it looks like the company's satisfied the SEC [7, 8, 9].

I appreciate Viceroy's articles because they identify things I wouldn't notice on my own.

They're like free learning guides.

But, I hate their writing style.

It makes me skeptical.

When you speak truth, you don't need to cuss

If a business is unsustainable, it'll fail regardless of how you write about it.

Yet, Viceroy chooses to write in an exaggerated, emotionally manipulative style.

Their articles tend to:

1. Focus on narrow slices of data without providing full context

2. Use exaggerated and emotionally-charged language

3. Make broad claims based on specific situations

In other words, they use a sensationalist writing style:

They use selective presentation of data and emotionally charged language to manipulate peoples' understanding of the situation.

I feel like they're trying to manipulate me.

I feel like I can't trust them.

The problem is incentives.

Viceroy makes money if the stock price falls.

In fact, it's in Viceroy's interest to make the stock price fall.

But, what if they have a history of being correct?

Here's a list of outcomes for NASDAQ and NYSE-listed companies they've reported on:

Result: 4 of 13 targeted companies filed for bankruptcy within 2-4 years of Viceroy initiating a campaign.

2 of those bankruptcies were largely caused by the legal costs associated with lawsuits triggered by the reports.

So, they have a decent track record.

But, the number of companies that came out okay reinforces my skepticism.

Despite my skepticism, we still sold

As mentioned, we sold my wife's holdings of ABR.

Key goals for my wife's income portfolio are:

1. Minimal risk of losing the principal investment

2. Medium to high dividend income

3. Low volatility

There're better options than ABR for achieving these goals.

Why?

ABR's situation

Let's take a look at ABR's latest:

1. Annual financial report (10-K) (from December 31, 2023) [10]

2. Quarterly financial report (10-Q) (from June 30, 2024) [11]

The business has 2 parts:

1. Making real-estate-related loans to businesses that own or operate real estate as part of their business.

2. Providing services related to loans made by governmental mortgage-issuing entities (like Fannie Mae, Freddie Mac, and the FHA).

From the 10-Q, ABR had income of $153M:

• $88M (57.5%) from interest on loans made

• $65M (42.5%) from other sources (mainly the services it provides)

And, management's overall business goal is to:

1. Grow the number of loans made and maximize the interest they produce

2. Grow the fees generated from loan services

3. Deliver the profits to shareholders via dividends

Most loans ABR makes are "bridge loans".

They're in the middle of what I like to call the "debt stack".

That is, if a bridge loan fails, ABR would get any available payout after "senior debt", but before anyone else.

However, ABR also makes "mezzanine" loans. These would get paid out after bridge loans. That makes them more risky.

Most of ABR's loans provide rights to the purchased property if the loan fails:

"Our bridge loans are predominantly secured by first mortgage liens on the properties." - From the 2023 10-K [10]

Even with these protections, it's a bad situation if a loan fails.

ABR may not be able to recover the amount it loaned out. Even if it does, it likely won't be able to make up for the lost interest income.

The big issue for ABR right now is that many of its borrowers are under stress:

"As a result of the current high interest rate environment, some of our borrowers have experienced, and may continue to experience, financial stress that has resulted in an increase in payment delinquencies, loan loss reserves and realized losses on certain loans within our portfolio." - From the 2023 10-K [10]

Note the use of the word "current" in "the current high interest rate environment".

The reason they say it this way is because most of the loans they make have interest rates that change over time.

The interest rates are based on what's called the secured overnight financing rate (SOFR). As that rate changes, the amount the borrower has to pay changes.

The projects funded by these variable-rate loans were started when the SOFR was low. Meaning their interest payments were low.

Then, the Federal Reserve System (the Fed) drastically increased interest rates. So, the borrower's interest payments drastically increased, too.

Those increased costs resulted in the projects becoming unprofitable. So, they've gotten into a situation where they can't make the payments on their loans.

Obviously, this is really bad for ABR.

To avoid situations where borrowers fail to meet their obligations (default) on their loans, ABR has been modifying problematic loans.

For example, from the Q2 2024 earnings call [14], CEO Ivan Kaufman said:

"This quarter, we successfully modified over $730 million of loans with $23 million of fresh capital being injected into these deals from the sponsors."

But, if these borrowers are struggling, how were they able to get the new capital?

During the Q4 2023 earnings call [12], an analyst asked for more detail about the loan modification process:

"Can you talk a little more about your process, how the modifications and extensions work, your gives and takes? Are you providing mezz...?" - Stephen Laws

Kaufman gave some examples:

• "...one of our borrowers who didn’t want to make this payment, and we’re deep, deep in the money. And we have five sponsors who want to take over that asset."

• "We have other ones where perhaps we have to give some concessions to attract more capital..."

• "Then you have certain circumstances where we have an asset that’s well in the money with a crappy borrower who’s going to hold us up and we’re going to have to fight through it and make it a non-accrual loan..."

• "We have sponsors who have personal guarantees on loans with the assets underwater, but their guarantees are worth hundreds of millions of dollars... we’re going to collect our money one way or the other. And, by the way, when we collect our money, you’re going to be paying a 24% interest rate, which you’re not going to want."

This all makes sense.

But, there wasn't an explicit answer about whether ABR itself is providing new capital via mezzanine loans.

If it is, it's effectively putting more money into problematic situations.

We know ABR gave a loan to a company to buy one of ABR's own foreclosed properties. So, it's easy to imagine that they might've provided additional funding to prop up problematic loans.

One tactic Kaufman mentioned for handling troubled loans is to accrue interest. That is, to let interest payments accumulate until they're paid at a later date.

From the Q1 2024 earnings call [13]:

• Steve DeLaney (analyst): "[The loans on accrual] will pay some and then you agree to just accrue some portion of the cash payment required. Is that correct?"

• Paul Elenio (CFO): "That is correct..."

It's important to observe that these loan modifications only provide temporary relief.

The borrowers still have a lot of work to do to get profitable.

Note: There's an entire section in the Q2 2024 10-Q [11] with detail on modifications performed.

Failing the quality test

Remember how mezzanine loans are more risky than bridge loans?

Unfortunately, ABR's loan portfolio has been trending towards increased risk [11]:

Additionally, the internally-assessed quality of the portfolio is also trending downward [11]:

The number of loans that aren't being paid has been increasing as well. ABR refers to these as "non-performing" loans.

"Loans are classified as non-performing once the contractual payments exceed 60 days past due." - From the Q2 2024 10-Q [11]

Non-performing loans went from:

• $274,152 on Dec 31, 2023 to

• $676,250 on Jun 30, 2024

That is, they increased by $402,098 (146.7%).

Bottom line: This business is in the middle of an uphill battle.

Back to incentives (again)

So, things are looking kind of bad.

But, let's go back to incentives.

ABR's team is incentivized to make this work.

They've been running this business for over 20 years.

In addition to being CEO, Ivan Kaufman founded the company. It's his baby.

The entire management team's careers, reputations, and personal finances are on the line.

They're highly incentivized to fight for a good outcome.

Their sincerity is reflected in the management team's purchases of their own shares in Q4 2023. The latest purchases were made at the end of November. Kaufman bought 40,000 shares and Elenio (the CFO) bought 5,000 [15, 16].

And then, there's this fun fact:

ABR survived the 2008 great financial crisis.

Preferred shares

As mentioned earlier, I bought ABR Series F preferred shares (ticker: ABR-PF).

Remember how preferred shares have different rights from common shares?

Here're the unique rights of the Series F shares [17]:

• Until October 30, 2026, they pay a dividend equal to 6.25% of $25.00 (i.e. $1.5625) annually

• From October 30, 2026 on, they pay a dividend equal to the greater of:

  • SOFR + 5.422% of $25 (i.e. 7.422% if SOFR is 2%) annually

  • 6.125% of $25 (i.e. $1.53125) annually

• Dividends are owed regardless of whether the company has profits or assets

• Dividends accrue (continue to be owed) if not paid

• The company has the option to redeem the Series F shares from October 12, 2026 on for $25 per share + any unpaid dividends

• They get paid out before common stock in the case of bankruptcy

  • This doesn't guarantee a payout - there might not be any funds available to be paid out in the case of a bankruptcy

• Common stock may not receive dividends until all dividends owed for preferred shares are paid

Given the company's current situation, these are really valuable rights.

As of writing, the market price for Series F preferred stock is $18.50 per share.

So, if ABR redeems the shares on October 12, 2026, the current price results in a total return of about $9.625/share (52%):

• Difference in price: $25 - $18.50 = $6.50

• Dividends: $1.5625 × 2 years = $3.125

Why would ABR redeem the preferred shares?

Because starting on October 30, 2026, the required dividend for the preferred shares will be quite high. The management team will most likely to want to replace them with less expensive debt.

The company did exactly this with their older Series A, B, and C preferred shares. They redeemed those on June 24, 2021 [18, 19, 20, 21].

Obviously, there's still risk involved.

But, the rights of the Series F preferred shares reduce the risk and make it easier to calculate their potential return.

Ben Graham doesn't like preferreds

The "father of value investing", Ben Graham, disliked preferred shares:

"Certain general observations should be made here on the subject of preferred stocks. Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one. The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner)." - Ben Graham, The Intelligent Investor [22]

But, some of the issues Graham mentions are addressed by the particular rights of the shares we're interested in. For example, our shares accrue dividends if they're not paid.

Graham's best student, Warren Buffet, also bought preferred shares in certain situations.

For example, he bought preferred shares from Goldman Sachs when the company was distressed in the 2008 financial crisis [23].

I don't think I'm as smart as Warren Buffet.

And, I don't think the ABR situation is the same as the Goldman Sachs situation.

But, I do think that sometimes preferred shares are worth a look.

Is it 10x?

If the preferred shares return 52% over 2 years, that's equivalent to a 23.3% compound annual return.

A 23.3% compounding annual return results in a 10x total return in 11 years.

So, this isn't a 10x.

But, it could contribute to getting there.

This investment's not about expecting the company to deliver huge increases in profits.

It's a belief that:

1. The business is in a challenging, but manageable situation

2. The management team is conducting its business legally

3. The management team will be able to get through the current situation

4. My capital investment supports that effort and provides an adequate reward

There's clearly substantial risk here.

But, the unique properties of the Series F preferred shares result in a risk-reward profile that seems reasonable to me.

A key factor is my belief that the company won't end up in bankruptcy. I expect ongoing challenges for the management team. But I think they'll make it through.

Of course, it's also an interesting learning opportunity.

This is the first time I've invested in a company via preferred shares.

I've made an investment of $2,000. I'm okay with losing the money (and counting it as tuition), if that's the ultimate outcome.

I'll post updates as learnings unfold.

References

1. U.S. DOJ probing Arbor Realty over loan practices, Bloomberg reports. Rueters. Viewed 2024-08-12.

2. United States Code (USC), Title 26, Section 856: Definition of real estate investment trust. Office of the Law Revision Counsel of the United States House of Representatives. Viewed 2024-07-29.

3. United States Code (USC), Title 26, Section 857: Taxation of real estate investment trusts and their beneficiaries. Office of the Law Revision Counsel of the United States House of Representatives. Viewed 2024-07-29.

4. Preferred stock. Wikipedia. Viewed 2024-08-08.

5. S&P 500 Return Calculator, with Dividend Reinvestment. DQYDJ. Viewed 2024-08-08.

6. Our Coverage: Arbor Realty Trust. Viceroy Research. Viewed 2024-08-12.

7. SEC request for comment to ABR, dated March 22, 2024. SEC filing. Viewed 2024-08-14.

8. ABR response to SEC March 22, 2024 request for comment. SEC filing. Viewed 2024-08-14.

9. SEC confirmation of completion of review of ABR filing, dated April 5, 2024. SEC filing. Viewed 2024-08-14.

10. Arbor Realty Trust 2023 10-K. SEC filing. Viewed 2024-08-13.

11. Arbor Realty Trust Q2 2024 10-Q. SEC filing. Viewed 2024-08-13.

12. Arbor Realty Trust, Inc. (NYSE:ABR) Q4 2023 Earnings Call Transcript. Transcribed by Insider Monkey. Viewed 2024-08-14.

13. Arbor Realty Trust, Inc. (NYSE:ABR) Q1 2024 Earnings Call Transcript. Transcribed by Insider Monkey. Viewed 2024-08-14.

14. Arbor Realty Trust, Inc. (NYSE:ABR) Q2 2024 Earnings Call Transcript. Transcribed by Insider Monkey. Viewed 2024-08-14.

15. State of Changes in Beneficial Ownership: Ivan Kaufman Purchases 11/27/2023. SEC filing. Viewed 2024-08-14.

16. State of Changes in Beneficial Ownership: Elenio Paul Purchases 11/27/2023. SEC filing. Viewed 2024-08-14.

17. 6.25% Series F Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock. SEC filing. Viewed 2024-08-13.

18. 240.12d2-2 Removal from listing and registration. Code of Federal Regulations, 17 CFR 240.12d2-2. Viewed 2024-08-14.

19. Notificatioin of Removal from Listing and/or Registration: 8.250% Series A Cumulative Redeemable Preferred Stock. SEC filing. Viewed 2024-08-14.

20. Notificatioin of Removal from Listing and/or Registration: 7.75% Series B Cumulative Redeemable Preferred Stock. SEC filing. Viewed 2024-08-14.

21. Notificatioin of Removal from Listing and/or Registration: 8.50% Series C Cumulative Redeemable Preferred Stock. SEC filing. Viewed 2024-08-14.

22. Graham, Benjamin. The Intelligent Investor. Harper & Brothers, 1959, p. 74.

23. The Goldman Sachs Group, Inc. Current Report: Sale of Series G Preferred Stock to Berkshire Hathaway Inc.. SEC filing. Viewed 2024-08-14.

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