Leon Cooperman’s roadmap for Arbor Realty

I have to admit I don’t know a lot about Leon Cooperman, except that I see him on CNBC every once in a while and they make a big deal of that like he’s a heavy weight.  Nevertheless, this was enough of an introduction so that when I saw his name come up on the questioner list of Arbor Realty’s second quarter call, I took notice.

Cooperman distilled the idea behind Arbor with clarity.  I’ve reposted the most relevant comment below but I would recommend reading the entire exchange (available from Seeking Alpha):

Lee Cooperman – Omega Advisors

Most exciting thing you said this morning, I am trying to understand if I am correct in my understanding. I have been said that you thought you can get a mid-teens leverage return on capital. So, I am trying to forget the linkage of FFO to the mid-teens leverage return on capital. Let’s just say we use an average number, make it easy for you, $8 book value at a 15% return, would imply like $1.20 or so of ongoing earnings and I am curious whether that is a goal that you see as realistic. How that relates to FFO and do you have a timetable in mind for when that kind of profitability to be achieved. This is well above we’re currently earning. And secondly, does the access to the deferred market make it likely that we won’t have to resort to any equity financing, anytime in the foreseeable future?

The story with Arbor is similar to what I laid out with Newcastle Investment (which I recently added back into my portfolio on news of the New Media spin-off).  The company has a pool of capital that is currently invested in low return assets (securities of their own CDO’s that they have purchased and legacy swaps that they hold), and as those assets run off (either naturally or, in the case of the CDO’s, as they are collapsed by the company) they will have capital available to purchase higher return assets.  The potential returns from what they can invest in (commercial real estate loans), is significantly higher than the legacy assets.

The business of Arbor is conceptually like a bank, and so I think its worthwhile to consider how you would think about the stock if it were instead called Arbor Bank and Trust or something of the like.  What you would be looking at is a company with a GAAP book value of $7.60 per share (Note: this is pre the recent equity issuance so a bit lower than that now) and with another $2 of embedded book not yet realized by GAAP.  At the end of the second quarter the company had a tangible common equity ratio over 20.

With a tangible common equity ratio of 20, if Arbor was a bank you would say they should go out and make more loans.  And that is basically the story here.  They are currently constrained with the equity that is tied up in CDO’s and swaps, but as that equity frees up they will be able to deploy it in higher return assets.  Return on equity right now is 7.5% and there is a fairly clear path to how that ROE can be increased to the 12-13% range (ie. make more loans and don’t take any write-downs).  At those level of ROE’s, the company is going to earn between $40-$43 million of funds from operations, or pretty close to $1 per share.  In comparison, the company announced their second quarter dividend at 13c (or 52c annually), up from 12c in the first quarter.

Why Arbor is not quite a bank

So what are the big differences between Arbor and a bank?   The two differences are that the funding base is entirely different and that the loan base is more concentrated.

Arbor has made progress in shoring up its funding base.  The company has issued two collateralized loan obligations in the last year, and has mentioned a third on the horizon.  The CLO’s allow for reinvestment of funds for 2 years before reverting to the natural run-off of assets.  Its not quite the stability of a deposit base, but its better than wholesale funding.

As for the loan book, I it is what it is.  The company originates bridge loans, mezzanine loans, junior participation, and preferred equity.  The loans are centered around commercial real estate.  It’s risky stuff.  If you think we are careening towards an imminent recession then Arbor’s book of commercial loans and bridge loans is probably not where you want to be.  Cash will undoubtedly do better.  But these guys have proven themselves to be sound managers of risks given the business they are in; they managed themselves through the 2008 debacle where many others did not.

Dilution

One of the biggest risks with Arbor is that, being a REIT, they are serial issuers of equity.  Over the long run if the company can generate good returns on that equity, that isn’t a problem.  But in the short run it causes the stock to crater on a bi-annual basis on news of a new equity issuance.

I was a little surprised they went for another equity issue so soon (6 million shares at a price of $7.08).   This is a bit concerning, because it didn’t really appear that the company needed more equity, Cooperman in fact asked the question on the second quarter conference call (August 2nd) and the answer was that they weren’t in the market.  Things change.  I’m going to give them the benefit of the doubt and presume that loan demand remains strong and that the June-July REIT sell-off followed by the uptick in their stock price brought on by Cooperman made them think they should get while the getting is good.  I added stock in the $6.80’s after it collapsed on the news, which is 4% below the offering price.

Conclusion

I hold Arbor primarily for the income, and thus I tend to hold it in accounts that are geared towards generating income.  Its not the sort of stock that I would own a lot of, because the business of making junior loans on commercial real estate is risky, but it provides a nice increase to the yield of the overall portfolio.  The potential for price appreciation is a bonus; if Cooperman is right and they can increase their loan book we could be looking at a $12-$13 stock in a year or two.  I would happily take that.