Over the past few years, many investors have been looking for ultra-high dividend yield investments. Until this year, interest rates were at extremely low levels around the world, making it difficult for investors to find high-yield investments without inappropriate risk. Today, interest rates are much higher, which improves the dividend investment landscape, but still generally weak relative to inflation. Moreover, the American economy is now in a technical recessionwhich means that many risky companies could soon experience a significant drop in profits and solvency.
Simply put, now is probably not the best time to load a portfolio with riskier stocks. Many sectors have seen their valuations fall from 2021 levels, but dividend yields have generally not risen with interest rates. This is especially true for higher-paying market segments, such as mortgage REITs. In my opinion, mortgage REITs are much riskier in the current environment than many investors believe. Many analysts focus on the high dividend yields in the sectors, not the potential for extreme asymmetric risk that accompanies their immense leverage. These risks are only beginning to surface as rising mortgage rates slow the real estate market, but I believe most mREITs will face larger permanent losses in the coming year.
The popular mortgage REIT Arbor Realty Trust (NYSE:ABR) is particularly interesting because it recently lost a quarter of its value in a matter of days, recouped much of those losses, and is potentially down again. Arbor is different from many MREITs because it focuses on commercial multifamily bridge loans (as opposed to agency titles) and has additional operations in originations and services. On the plus side, Arbor’s diversified platform reduces its exposure to interest rate risk (a critical risk in most mREITs), but the company has relatively large economic exposure.
There’s a lot to love about Arbor, but there are countless articles about its benefits and virtually none that examine its significant risks. Many analysts focus on historical data such as dividend increases and its historical dividend coverage, but not on the fact that it has increased its leverage and is exposed to significant macroeconomic risk. In the current economic downturn, Arbor may be an unsuitable investment for many income-oriented investors.
A closer look at Arbor’s strategy
Arbor operates through two primary businesses, its structured business, which invests primarily in commercial mortgage bridge financing, and its agency business, which originates and manages mortgage products for government-sponsored entities. The company’s structured businesses offer relatively stable cash flows with significant exposure to the credit cycle. In contrast, its original business is highly cyclical, weakening as commercial sales decline, but exhibits some resilience due to its mortgage servicing counterparts.
Higher interest rates are troublesome for Arbor’s origination platform. Abror’s agency business operates by originating commercial mortgage loans and selling them to a government agency such as Fannie Mae (OTCQB:FNMA) (which packages them into mortgage-backed securities). In many cases, Arbor acts as the servicer of these loans, providing the business with income without taking financial risk. In general, mortgage servicing rights appreciate mortgage rates because higher rates lead to lower refinance risk. The spike in rates has sent the MSR market skyrocketing as many lenders view the asset as a rare hedge against mortgage rates.
Assets in Arbor’s portfolio are generally higher interest short-term loans to commercial property owners. These assets have minimal direct interest rate risk compared to agency-centric mREIT portfolios like Annaly (NLY). As you can see below, the company’s book value has increased overall with the sharp rise in US rates:
Higher interest rates may be beneficial for Arbor’s structured business. That said, the company faces indirect credit risk, as a spike in interest costs can increase delinquencies. In the second quarter, 98% of Arbor’s structured business was bridge lending. Bridge loans are often given to borrowers looking to improve a property over a short period of time, paying off the bridge loan with a traditional loan once the improvements are complete. These loans had a weighted average yield of 5.47% and a weighted average term to maturity of 23.6, or essentially two years.
CRE market slowdown weighs on Arbor
The main risk with these loans is a decline in property values, as this would prevent borrowers from repaying the bridging loan in full as they would not obtain sufficient traditional financing. The short-term nature of bridge loans exacerbates this risk. This risk has not materialized in recent years as the value of commercial properties has steadily increased due to excessively low interest rates. Soaring interest rates caused the trend to reverse, with commercial property sales volumes slowing significantly.
Inflation has also increased the risk of default on bridge loans. During the company’s recent earnings call, its management noted that its customers were seeing construction costs rise more than 30% in the past year, leading Arbor to report construction delays. Prime multifamily cap rates were still low at ~4.43% in Q2, but were up 30 basis points from the prior quarter. Most commercial real estate transactions take several months to negotiate and close, so the prices and sales figures we see today are likely based on market fundamentals from early 2022 before rates rose. in a spectacular way. Given the magnitude of the rate hike, I strongly believe that cap rates will likely rise much more and sales volumes much lower.
Inflation is also an indirect risk for Arbor, as rising construction costs pinch borrowers. With the sales market slowing and capitalization rates likely to rise (falling property values), Arbor borrowers will likely see costs rise and sales decline. Real estate is a “low-margin, high-leverage” business, so it seems likely that many borrowers will struggle to repay their short-term bridge loans in Arbor. Arbor has collateral because its loans are typically first lien, but that collateral may not be worth as much as it was in 2021 as the market slows.
Arbor Leverage Compound Risk
Rising interest rates create credit risks not only for Arbor’s borrowers, but also for the company itself. Arbor recently priced a $250 million debt offering at 7.5% to pay off a loan due this year at 4.75%. This means that Arbor’s borrowing costs on refinanced debt have increased by almost 60%. As mentioned in its “Interest Rate Risk” segment of its latest 10-K, the company has almost as much exposure to floating rate assets as it has floating rate debt. Yet its fixed-rate debt will become much more expensive over the next few years. The Company’s fixed rate loans will have higher yields, reduced by higher interest charges.
At first glance, rising interest rates should not have a direct negative impact on Arbor’s cash flow as it impacts both assets and liabilities. However, more dramatic changes in net income and interest charges, combined with high leverage, can create significant income volatility. Arbor is a highly leveraged company with total liabilities to assets of 83.4%. The company also recently issued preferred shares, bringing its total liabilities to common equity ratio to 6.8X. See below:
Arbor has increased its overall leverage over the past few years and has the highest leverage since the Great Recession. For common stock investors, Arbor has significant leverage primarily in a relatively high-risk portfolio. Most of its assets are highly exposed to a downturn in the commercial real estate market, with its largest segment (bridge loans) being at higher risk due to falling real estate sales and the construction cost crisis . Previously, Arbor’s high leverage allowed it to generate strong cash flow returns on its equity. However, as Warren Buffett said, “It’s not until the tide goes out that you find out who swam naked.” In my opinion, the tide is going out and Arbor is definitely not conservatively positioned.
Overall, I’m very bearish on the ABR and think the stock is likely to decline over the coming year as its balance sheet risks surface and its creations slow. This downside risk is catalyzed by the negative, but delayed, effects of rising interest rates on the commercial real estate market. Given Arbor’s high leverage, the downside risk to its common stock is quite substantial because it wouldn’t take a substantial increase in loan losses (as a percentage of loan value) to destroy much of its ordinary shares. In my opinion, its current provisions for loan losses are minimal compared to the potential risk of the current macroeconomic environment on commercial real estate.