Arbor Realty: The Dividend Lesson (NYSE:ABR) (2024)

Don’t only look at the dividend yield

Arbor Realty Trust, Inc. (NYSE:ABR) can seem very appealing to income-oriented investors. The stock is currently yielding 10.73% on an FWD basis. The yield is actually higher than its P/E of 10.32x (i.e., if you ignore the percentage sign and only consider the numerical values). Moreover, there are other positives to consider besides the high yield thanks to its differentiating business model. ABR's business model is differentiated from other mortgage real estate investment trusts, or mREITs, in a few important ways such as its focus on multifamily assets and its annuity-based business model. The multifamily asset class is generally considered to be more defensive than other real estate sectors, such as commercial or industrial. Multifamily assets tend to be less volatile and produce more consistent income, even during economic downturns. In the meantime, ABR’s business model is designed to generate a steady stream of income over time, kind of like an annuity.

And historical data certainly support the above traditional wisdom as you can see from the following charts. These charts show ABR’s tangible book and also its dividends, both on a per share basis, over the past decade. To provide context, the charts also show two other leading mREIT stocks, AGNC and NLY. The first chart clearly demonstrates the stability of its assets. In the long-term, its tangible book value steadily appreciates, while both AGNC and NLY have suffered a chronic loss of book value. And the second chart demonstrates its earnings stability. Here I am using dividend payouts to approximate true owners' earnings, which is a very good assumption in my view for mREIT stocks. As seen, ABR stands out here again as the stock that has consistently increased its earnings over time while both AGNC and NLY have suffered declines over time.

Against this backdrop, the thesis of this article is to caution potential investors about the caveats hidden behind the 10%+ yield. I will detail a total of 3 in the remainder of this article. First, I will first explain why its current yield is not as high as on the surface once properly benchmarked. Second, I will explain why it also trades at a considerable valuation premium at its current prices. And finally, I will discuss a few profitability headwinds I see on the horizon.

~10% yield is not as high as on the surface

A 10% dividend yield has a magic ring to it among income investors. Besides being a nice and round number, it also represents a potential return that is significantly higher than most alternatives such as CDs, corporate bonds, or high-yielding stocks. However, any yield needs to be properly contextualized – at least against two benchmarks in my view.

First, it needs to be benchmarked against its own historical track record as shown in the chart below. As seen, ABR has been yielding an average of 9.98% in the past 4 years. As a result, its current FWD yield of 10.77% is only marginally above the historical average. Its TTM yield of 10.3% is even lower (among the lowest levels in the past 2 years or so).

Second, it needs to be benchmarked against risk-free rates, which serve as the gravity of all asset valuation. A higher risk-free rate automatically discounts any dividend payments more heavily. As seen in the second chart below, the yield from 10-year treasury bonds averaged 2.26% in the past 5 years and currently hovers around 4.3%. As such, ABR’s current ~10.3% TTM yield is about 6% above the 10-year treasury rates. In contrast, in the past few years, the spread has been close to 8% (9.98% average dividend yield minus 2.26% average 10-year treasury rates). A high risk-free interest rate would also cause other 2^nd effects for mREIT stocks because it drives up mortgage rates and therefore could discourage new loans. I will detail these headwinds in the final section.

Valuation risks

The next chart shows ABR’s valuations in terms of the P/TBV ratio. As mentioned earlier, it is certainly a huge positive for ABR that its TBV has steadily appreciated over the long term. However, the recent price rallies have outpaced the book value growth, resulting in a relatively expensive valuation. To wit, its average P/TBV ratio has been about 1.07x historically in the past decade. Its current P/TBV ratio of ~1.25x is therefore more than 16% above the historical average. It is a sizable premium in absolute terms. Moreover, if you consider the relatively narrow range of fluctuations in its P/TBV as seen, such a premium is also considerable in relative terms as well.

Other Risks and Final Thoughts

As aforementioned, the increase in risk-free interest rates has driven up mortgage rates in tandem substantially over the past few years. To wit, mortgage rates now sit near a multi-year peak level as seen in the chart below. According to the data here, the current 30-year fixed rate is 7.18%, the highest level since at least 2018. Looking ahead, I see good odds that the risk-free rates would persist at this elevated level given the recent inflation data. As a result, I see mortgage rates remain elevated too.

Admittedly, ABR is relatively well-positioned to withstand higher mortgage rates for the differentiating business model discussed upfront. However, there are still a few ways in which its profitability could be hurt by persisting high mortgage rates. First, I expect pressure on its origination volume. If high mortgage rates and high inflation persist, the combined effects could dampen demand for new multifamily loans, leading to a lower origination volume for ABR. Second, I also see the possibility for prepayment rates to increase. If mortgage rates remain elevated, it’s only logical for borrowers to prepay their loans as much as possible to minimize their interest payments, which translates into a reduction in ABR’s interest income. And finally, as mentioned, higher risk-free interest rates, especially combined with a higher mortgage rate at the same time, can cause the value of ABR’s existing loans to decline. A reduction of its loan portfolio, combined with the P/TBV premium just mentioned, further adds to the valuation risks.

All told, ABR certainly offers several key positives, and its current 10%+ yield is only the starting point. In my view, its consistent dividend payouts are only a reflection of the differentiating factors in its business model.

However, just as it is only a reflection of the positives, it can also reflect the negatives. And it is precisely the goal of this article to caution potential investors of such negatives. The key takeaway is that the 10% yield is insufficient to compensate for the risks of Arbor Realty Trust, Inc. in my view for at least 3 reasons. First, it is not as high as it seems once properly benchmarked. Second, it is currently trading at a sizable premium. Thus, valuation correction is very likely, which could offset its dividend payments. Third, I see several profitability headwinds ahead, which could pressure its income and also its loan portfolio valuation (and further compound the valuation risks).

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Envision Research

Envision Research, aka Lucas Ma, has over 15+ years of investment experience and holds a Masters with in Quantitative Investment and a PhD in Mechanical Engineering with a focus on renewable energy, both from Stanford University. He also has 30+ years of hands-on experience in high-tech R&D and consulting, housing sector, credit sector, and actual portfolio management.

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