ARBOR REALTY TRUST INC quarterly report, Q3 FY2011

Business context and reporting period

Arbor Realty Trust, Inc. is an externally managed REIT investing primarily in multifamily and commercial real estate loans and investments, including bridge, mezzanine and participation loans. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2011; balance-sheet comparisons are with December 31, 2010.

Financial performance and position

For the first nine months, operating cash flow was negative $4.7 million, investing cash flow negative $11.2 million, and financing cash flow negative $25.8 million. Cash declined $41.8 million from year-end. Restricted cash is largely committed to CDO requirements, loan commitments and related purposes, and is not equivalent to unrestricted liquidity.

Net loans and investments were $1.330 billion, after $170.4 million of loan-loss allowances; gross unpaid principal was $1.514 billion. The allowance covered 23 impaired loans with $291.9 million of carrying value before reserves. Real estate owned was $148.8 million, up from $22.8 million, mainly following acquisition of hotel and multifamily portfolios.

Reported debt included $1.013 billion of CDO obligations, $158.1 million of junior subordinated notes, $85.5 million of notes payable, $14.9 million of repurchase and credit-facility borrowings, and $115.9 million of mortgage debt on owned or held-for-sale real estate. Management reported compliance with debt covenants at September 30. Book value per share was $7.89, versus $8.25 at year-end; management’s non-GAAP adjusted book value was $12.26, versus $12.64.

Material changes versus comparable periods

• Nine-month net interest income fell 42% year over year as average loans and investments declined and asset yields fell; lower interest expense partly offset the decline.
• Property operating income rose to $21.3 million for nine months from $1.2 million, primarily because Arbor acquired hotel and multifamily properties in early 2011. Related property expenses and depreciation also increased substantially.
• Loan-loss provision, net of recoveries, declined to $18.3 million from $61.2 million for nine months. The allowance balance fell from $205.5 million to $170.4 million, reflecting charge-offs, recoveries and transfers of loans into real estate owned, not solely improved credit quality.
• The prior-year comparison is heavily affected by unusual debt-extinguishment gains: nine-month 2010 included $229.3 million, principally the $158.4 million gain on a discounted Wachovia payoff and gains from discounted CDO-note repurchases. Nine-month 2011 included $7.9 million of debt-extinguishment gains.
• Q3 2011 included a $5.1 million gain from repurchasing CDO notes at a discount and $3.7 million of equity-affiliate income, primarily a $3.6 million property-sale gain. These helped offset operating losses.
• Average asset yield and borrowing cost for Q3 were 4.61% and 3.51%, respectively; for the nine months they were 4.58% and 4.15%. Management attributed lower asset yields to LIBOR, suspended interest on non-performing loans, and lower rates on modified or refinanced loans.

Outlook, risks, contingencies and unusual items

The filing provides no formal earnings or revenue guidance. Management said existing funding sources should meet near-term and long-term liquidity needs, while noting that long-term requirements depend on obtaining additional debt or equity financing. It described commercial real estate recovery and financing-market conditions as uncertain and said it expected continued loan modifications and delinquencies if the downturn persisted.

• Credit exposure remains significant: five unrelated borrowers represented approximately 29% of total assets, and 41% of loan and investment balances were tied to properties in New York. Ten loans were classified as non-performing, with approximately $13.9 million net carrying value after $36.1 million of reserves.
• Arbor had $20.6 million of unfunded loan commitments; about $18.4 million of related restricted cash and CDO III capacity was available for the CDO-financed portion. A $50 million warehouse facility had $11.7 million outstanding and includes liquidity, net-worth and other covenants.
• All three CDOs passed overcollateralization and interest-coverage tests at the October 2011 determination date. CDO III’s overcollateralization ratio was 108.47%, compared with a 105.60% limit; a breach could divert cash flows away from Arbor and impair liquidity.
• Interest-rate swaps had a $50.6 million fair-value liability, and Arbor had posted $24.0 million of cash collateral. Further adverse valuation changes could require additional collateral. Management estimated a 0.25 percentage-point LIBOR increase would raise annual net income and cash flow by about $0.7 million, while a decrease would reduce them by about $0.3 million, assuming balances remained unchanged.
• Three Extended Stay-related lawsuits name subsidiaries or affiliates among 73 defendants. The complaints seek at least $2.1 billion in damages, plus punitive damages, and the return of more than $50 million allegedly received by preferred-unit holders. Arbor said it intends to defend the actions vigorously; the claims are allegations, not an adjudicated liability.
• The company disclosed related-party and governance conflicts: ACM externally manages Arbor, and senior executives have roles at ACM; ACM held 21.6% of Arbor’s voting power. The filing also describes loans involving properties acquired from ACM or affiliates.
• No common dividend was declared for Q3. Junior-note terms restrict distributions and generally require payment in stock to the extent permitted, with the stock-distribution arrangement tied to terms extending to 2012. Arbor repurchased 725,988 shares for $3.0 million through September 30 and reported completing the remaining authorization in Q4.

Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

• Whether cash generation and unrestricted liquidity can support debt service, loan commitments, collateral calls and operating costs as cash balances decline.
• Credit migration, collateral valuations, future charge-offs and recoveries, and the performance of loans under modification or extension.
• CDO covenant headroom, particularly CDO III, and the timing and terms of CDO debt amortization and refinancing.
• The sustainability of net interest income given lower asset yields, non-performing loans, LIBOR exposure and swap collateral requirements.
• The status, potential exposure and any subsequent developments in the Extended Stay litigation, and the outcome of the Alpine Meadows settlement and other disclosed post-quarter transactions.
• The basis and assumptions underlying management’s adjusted book value measure, loan-loss estimates and fair-value measurements, which rely in part on significant management judgments.