ARBOR REALTY TRUST INC annual report, FY2017

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Business context and reporting period

Arbor Realty Trust, Inc. (NYSE: ABR) filed this Form 10-K for the fiscal year ended December 31, 2017. The company operates a Structured Business, investing primarily in commercial real estate loans, and an Agency Business, originating, selling and servicing multifamily loans through Fannie Mae, Freddie Mac, HUD and other programs. The Agency platform was acquired in July 2016, so 2017 includes a full year of its results while 2016 includes only a partial year. Arbor internalized its management team and ended its external management agreement on May 31, 2017.

Financial performance and key metrics

  • Income: Net interest income was $66.1 million, up 20% from $55.1 million. Total other revenue rose 102% to $190.5 million, driven largely by Agency loan sales, mortgage servicing rights (MSRs) and servicing revenue. Net income was $97.5 million; net income attributable to common stockholders was $65.8 million, up 54% from $42.8 million. Diluted earnings per common share were $1.12 versus $0.83.
  • Non-GAAP measures: FFO was $94.3 million ($1.17 per diluted share) and AFFO was $83.9 million ($1.04 per diluted share). The company cautions that these measures are not cash flow or liquidity measures and may not be comparable with other companies’ calculations.
  • Net interest and Agency margins: Structured Business average asset yield was 6.27%, versus a 4.67% average borrowing cost. Agency loan originations were $4.46 billion and sales were $4.81 billion; sales margin was 1.51%, down from 1.65% in 2016. MSR income as a percentage of loan commitments was 1.77%, down from 2.11%.
  • Portfolio: Structured loan and investment unpaid principal balance was $2.65 billion across 170 investments at year-end, up from $1.79 billion and 144 investments. Multifamily represented 73% of UPB. The Agency servicing portfolio grew 19.6% to $16.21 billion across 3,322 loans.
  • Cash flow and liquidity: Operating cash flow was $460.8 million, investing cash outflow was $907.9 million, and financing cash inflow was $412.8 million. Operating cash flow benefited substantially from Agency loan sales exceeding originations by $370.0 million; it should not be read as recurring earnings cash flow without considering loan-sale timing. Cash and cash equivalents were $104.4 million, with an additional $139.4 million of restricted cash at year-end. Management said available funding sources and market access were adequate for anticipated needs.
  • Debt and capital: Total debt was $2.53 billion, up from $2.02 billion; total assets were $3.63 billion and total equity was $864.6 million. Arbor issued $143.8 million of 5.375% convertible notes due 2020, issued additional 6.50% convertible notes, completed three CLOs, formed a $100 million debt fund, and raised $76.2 million net in a common-stock offering. Structured portfolio leverage, excluding specified facilities, was 72%, versus 64% a year earlier. The company reported compliance with debt covenants at year-end.
  • Dividends: Common dividends declared totaled $0.72 per share for 2017. In February 2018, the board declared a quarterly common dividend of $0.21 per share, up from $0.17 in the comparable prior-year quarter. Preferred dividends continued at stated series rates.

Material changes versus the prior comparable period

  • Results reflect the first full year of the acquired Agency platform. Agency originations more than doubled year over year, and loan sales increased from $1.49 billion to $4.81 billion; the year-over-year comparison is not like-for-like because the acquisition closed in July 2016.
  • Structured Business originations increased to $1.84 billion from $847.7 million, while the portfolio expanded and average loan yields rose. Higher balances and borrowing costs contributed to a 42% increase in interest expense, but net interest income still increased 20%.
  • Employee compensation and benefits increased to $92.1 million from $38.6 million, reflecting the Agency platform’s full-year contribution, growth and internalization. Total other expenses increased 35% to $149.9 million.
  • Common-stockholder income increased, but included significant items: a $7.1 million gain on extinguishment of debt and a $5.3 million deferred tax benefit from the newly enacted U.S. tax rate reduction. Equity affiliates moved from $13.0 million income in 2016 to a $3.0 million loss in 2017, including Arbor’s share of a litigation settlement.
  • Total loans and investments, net, rose to $2.58 billion from $1.70 billion, while debt rose by approximately $513 million. Cash declined $34.3 million; restricted cash increased $110.1 million, primarily from CLO IX proceeds for future loan funding.

Outlook, risks, contingencies and unusual items

  • Management outlook: Management stated that the three Federal Reserve rate increases in 2017 had not significantly affected the business and did not anticipate a significant near-term decline in origination volume or profitability, citing historically low rates and a measured expected pace of future rate decisions. This is management’s expectation, not a quantified earnings forecast.
  • Agency and GSE exposure: The Agency Business depends heavily on GSE and HUD programs, servicing income and sale margins. The 2018 Fannie Mae and Freddie Mac multifamily origination caps were set at $35 billion each, down $1.5 billion from 2017; future cap changes, housing-finance reform or loss of lender approvals could materially affect results. Fannie Mae DUS risk-sharing exposure is supported by a $30.5 million allowance; Arbor reported $42.0 million of letter-of-credit collateral and expects to fund an additional $27.7 million of restricted liquidity over 48 months, assuming no portfolio changes.
  • Credit and property risks: Two loans with net carrying value of $29.1 million were classified as non-performing at year-end; impaired loans had $62.8 million of reserves. Arbor recorded $3.2 million of real-estate-owned impairments, including a further $2.7 million impairment of a hotel property. Six land-development loans totaling $120.0 million were extended to September 2018; they have no current pay rate, and collection of accrued interest has been suspended.
  • Funding and interest-rate risks: The business relies on debt and equity markets, CLOs, warehouse facilities and repurchase agreements. Floating-rate assets and liabilities, maturities, collateral calls, covenant tests and refinancing availability can affect spreads and liquidity. The filing’s sensitivity analysis estimates that a 50-basis-point LIBOR increase would raise annual net interest income by $2.1 million, while a 50-basis-point decrease would reduce it by $0.8 million, based on stated assumptions.
  • Legal and related-party matters: Arbor disclosed the Extended Stay litigation, in which an amended complaint seeks approximately $139 million in aggregate from multiple defendants, including affiliates. No loss was accrued because management believed a loss was not probable and could not be reasonably estimated. The filing also describes a separate potential guaranty exposure of up to $3.1 million related to an equity-affiliate settlement, for which no accrual was recorded. Numerous loans and business relationships involve officers, the CEO or the former manager; review related-party disclosures and approval procedures.
  • Other items: Arbor paid $25.0 million to internalize management. A purchase-price allocation correction increased goodwill and other liabilities by $4.9 million, with no effect on reported operating results. The 2017 statements include the Tax Cuts and Jobs Act’s reduction of the corporate tax rate to 21%; management expected a benefit to the taxable REIT subsidiary.

Most important facts for investors to verify

  1. How much of 2017’s earnings growth reflects durable recurring net interest and servicing income versus acquisition timing, MSR valuation and other nonrecurring items?
  2. Whether 2018 Agency originations, sales margins, MSR income and servicing growth can be sustained under GSE caps and changing program rules.
  3. The credit quality and recovery outlook for non-performing and impaired loans, the land-development exposures, and the collateral underlying real-estate-owned assets.
  4. Debt maturities, facility renewals, CLO covenant headroom, collateral requirements and the liquidity needed to fund commitments and GSE obligations.
  5. The ultimate exposure, status and possible financial effects of the Extended Stay litigation and the equity-affiliate guaranty, as well as the governance and economics of related-party lending.
  6. Whether the $0.21 quarterly common dividend is supported by recurring cash generation after debt service, required investment and REIT distribution needs.