Arbor Realty Trust Inc (ABR) 2006 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2006 Arbor Realty Trust earnings conference call. My name is Jeremy, and I will be your coordinator for today.

[OPERATOR INSTRUCTIONS]

As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to your host, Mr. Paul Elenio, Chief Financial Officer. Please proceed, sir.

Thank you, Jeremy. Good morning, everyone, and welcome to the quarterly earnings call for Arbor Realty Trust. This morning, we will discuss the results for the quarter and nine months ended September 30th, 2006. With me on the call today is Ivan Kaufman, our President and Chief Executive Officer.

Before we begin, I need to inform you that statements made on this earnings call may be deemed forward-looking statements that are subject to risks and uncertainties, including information about possible or assumed future results of our business, our financial condition, liquidity, results of operations, plans and objectives.

These statements are based on our beliefs, assumptions and expectations of future performance, taking into account the information currently available to us. Factors that could cause actual results to differ materially from Arbor's expectations in these forward-looking statements are detailed in our SEC reports.

Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today. Arbor undertakes no obligation to publicly update or revise these forward-looking statements to reflect events to reflect events or circumstances after today, or the occurrences of unanticipated events.

I'll now turn the call over to Arbor's President and CEO, Ivan Kaufman.

Thank you, Paul, and thanks to all of you who are joining us on the call today. As the press release we issued this morning indicated, the strong operating results for the third quarter reflects our commitment to enhancing the long-term value of our company and franchise.

Before Paul reviews the financial results, I'd like to comment on some of the strategies we have employed and how we are faring in today's market. First, as mentioned, in the press release, we added two new equity kickers to our portfolio. These equity kickers are in the form of 25% profit interest and are part of approximately 13 million in loans we originated during the quarter on two multifamily properties.

Both properties are owned by the same borrower, who is an experienced owner-operator and a repeat customer of Arbor. While these two equity kickers are on relatively small deals, we continue to demonstrate our ability to add these transactions to our portfolio, which will allow us to share in the upside of real estate. As we have said before, these equity interests are an important part of our business model and we believe in the long-term value and the positive impact they will have on earnings over time.

We continue to improve our capital structure and the right side of our balance sheet. In the third quarter, we sought to realize the financial benefits of the trust-preferred securities we issued in the second quarter by utilizing these funds to support new originations. During the quarter, we swapped out 75 million of full trust-preferred securities to fixed rates for a period of five years. To date, 140 million of the 223 million of trust-preferred securities have been swapped, at an average fixed rate of 7.70%.

In addition, we increased the capacity within one of our warehouse facilities by $200 million and in October we added a $150 million warehousing debt facility with a new financial institution. We also believe it will be beneficial to issue another CDO, which we are actively pursuing. Due to market conditions, collateral accumulation and other factors, there can be no assurance that a third CDO will be completed.

As we mentioned on our last few calls, we had an unusually high average balance of restricted cash outstanding relating to our CDOs for the last three quarters, which impacted short-term earnings. This was the result of needing sufficient collateral to fund our second CDO, which had a ramp-up feature and increased loan payoffs during 2006.

Although the average balance of restricted cash was approximately 80 million during the month of October, we had approximately 50 million of restricted cash outstanding at October 31st. We believe the optimum level of restricted cash on average to be around 30 million a quarter and we remain actively focused on managing the excess cash in our CDOs to reduce it to the appropriate levels.

The market remains extremely competitive. As we have [mentioned troubled] times, we continue to focus on improving the credit quality of our portfolio by originating transactions more in the middle of the capital structure with lower loan to values. In fact, 85% of our third-quarter originations were in first-lien positions and the loan to value of our portfolio was 69% at September 30th, 2006, down from 75% at the same time a year ago.

Although this strategy has put some pressure on our margins, these assets create additional stability in our portfolio, and with the improvements we have made in our financing facilities by reducing borrowing cost and increasing leverage, provides us with superior risk-adjusted returns.

In line with this overall strategy, we continue to focus on increasing the amount of longer-term fixed-rate loans in our portfolio. As of September 30th, approximately 25% of our portfolio was fixed-rate product and our goal is to increase this percentage going forward. The loans are attractive to us, because they generally include prepayment protection, which creates a more stable return for our portfolio and we're able to lock in spreads by swapping out the rates in our CDOs.

In the third quarter, we closed approximately 300 million of new loans and investments, of which 288 million was funded. We experienced 212 million of runoff this quarter, of which 26 million was retained new loans and 186 million weighted as sold or refinanced outside of Arbor.

This resulted in net growth in our portfolio for the quarter and 28% for the nine months ended September 30th, 2006. In addition, this growth was heavily weighted toward the end of the third quarter, so we will receive the full benefit of the income on these investments going forward.

I wish to emphasize that our manager, Arbor Commercial Mortgage, has elected to take 100% of -- instead of management fee, in stock. As we've consistently stated, the manageability of the long-term value of Arbor's common stock and is [fully] committed in keepings its interest aligned with shareholders.

A special committee of independent directors completed its analysis of the potential internalization of the management structure. The committee engaged outside advisers to assist in this evaluation and has concluded that it is not in the best interest of shareholders to internalize at this time. The estimated cost of evaluating internalizations was approximately $450,000, of which 325,000 has been expensed to date and 125,000 will be expensed in the fourth quarter.

Lastly, as previously announced, we entered into a stock repurchase program and repurchased up to 1 million shares of our stock. As of today, we have purchased approximately 280,000 shares. The plan has a term of six months and there is no guarantee as the exact number of shares we will purchase.

I will now turn the call over to Paul to take you through some of the financial results.

Thank you, Ivan, and good morning, again, everybody. As noted in the press release, our earnings for the quarter were $0.63 per common share on both a basic and fully diluted basis. During the quarter, we recorded approximately 700,000 of income related to an interest rate swap on one of our trust-preferred securities. Absent the net impact of this amount, our earnings for the quarter were $0.60 per share.

This income is the cumulative effect of a change in accounting treatment as a result of new informal technical interpretations from the SEC. I would like to point out that future changes in the market value of this interest rate swap will cause the 700,000 to be recaptured as a reduction of net income as the value of the swap moves to maturity. Other than that, the numbers in the press release are fairly self explanatory, but I'll highlight a few points I believe may benefit from some clarification.

First, our average balance in core investments grew about 54 million from last quarter. As Ivan mentioned, our portfolio growth of 88 million was heavily weighted towards the end of the third quarter, which means we will receive the full economic benefit of this growth in future quarters.

In addition, the yield for the quarter on these core investments was 10.63%, compared to 10.60% for the second quarter. As we've mentioned on last quarter's earnings call, our yield for the second quarter included income from the acceleration of fees and IRR lookbacks, which are part of the normal course of our business.

This held true again this quarter. However, the impact of these items was not as large as in the second quarter. So, for comparative purposes, the yield on core and investments before these items was approximately 10.44%for this quarter, compared to around 10.35% for the second quarter, a nine basis point increase.

This increase is predominantly due to increased interest rates on a floating-rate portfolio due to the rise in LIBOR. This was partially offset by lower yields on new originations as compared to the yields and the loans that paid off during the quarter. Our average cost of funds increased 13 basis points from 7.11% for the second quarter to 7.24% for the third quarter. This was due to the rise in LIBOR, partially offset by reduced borrowing cost as a result of swapping out certain of our variable-rate debt to fixed rates related to our CDOs and trust-preferred securities.

In addition, the average value on our debt facilities grew by 66 million from last quarter. The average leverage on core assets was around 71% for the second and third quarters. Including the trust preferreds as debt, the average leverage was 84% for the second quarter, as compared to 85% for the third quarter.

Our average restricted cash balance was around 90 million for both the second and third quarters. As mentioned, we did have an unusually high balance of restricted cash outstanding in the last three quarters, which had an impact on short-term earnings. The effect of this increase on interest expense was partially offset by earnings on the restricted cash balances, which were included in interest income.

Including restricted cash, our average leverage for the third quarter was 66%, compared to 67% for the second quarter. Our overall leverage ratio was 2.1 to one at September 30th, as compared to 1.8 to one at June 30th. If you include the trust-preferred securities as debt, the overall leverage ratio was 4.0 to one at September 30th and 3.5 to one at June 30th.

The increased leverage is predominantly due to our ability to effectively deploy the funds raised from the trust-preferred securities issued in prior quarters into interest-earning assets. There were no other significant changes in the balance sheet, but I would like to point out that the weighted average number of shares outstanding on a diluted basis has deceased as a result of the shares we had purchased during the quarter from our stock buyback program.

Operating expenses were fairly flat, as compared to the previous quarter. Stock-based compensation expense, which is a non-cash expense, decreased 0.5 million from the second quarter, largely due to stock grants issued to key employees in April 2006.

Finally, I would like to point out that we did include a schedule summarizing our equity participation interest and IRR lookbacks this quarter. As Ivan stated, we did originate two new investments with equity kickers during the quarter. This brings the total number of equity kickers in our portfolio to 11. As we said before, these equity interests may cause our earnings to be lumpy, but these investments are a significant component of our business model and we believe in their long-term value and the positive contribution to earnings they may have over time.

With that, I'll turn it back to the operator and we'll be happy to answer any questions you may have at this time.

Certainly, sir.

[OPERATOR INSTRUCTIONS]

And your first question is from the line of Don Destino of JMP Securities.

Hey, guys. Thanks for taking my questions and congrats on the nice quarter. I've got a few of them. The first one, Ivan, is on the decision to at least for now not proceed with internalizations. Can you talk a bit about what -- either what has changed since you first started considering internalization, or maybe what expenses you hadn't considered, or what the findings were that led to the conclusion?

Okay, I guess a little historical perspective is important here. We always thought that than external management company was an efficient structure, especially given our size, and I guess what we were doing on 144A back with JMP, it wasn't a really accepted practice. And we, I guess, were on of the first at that point kind of that came out with an externally managed structure.

As such, we put an enormous effort into structuring our management agreement to address the concerns in he market. And I believe to date our management agreement has become the model within the market and is probably the best management agreement out there. But there was always a little bit of an overhang and a drag and almost a thought within the market and the analysts that we'd be better valued and it would be better for the stock and the franchise to internalize as soon as possible.

And that is something that we always had expressed that we would consider doing. And, as we continued to grow our business, we were committed to evaluating that. I guess as more companies became externally managed and people understood our management agreement and that was very favorable, the more we went on, the less significant it became to the investment community for us to internalize, but we have that obligation and our board had that obligation to evaluate it, which they did.

We believe, and I didn't need to hire outside consultants or compile an independent board, to understand how this business works, but we did all that and went through the exercise. And we spent a lot of money, unfortunately, but that's the process you have to go through.

But, given the termination provisions, given the variability of our staffing, giving the leverage we get off the manager's franchise, it was pretty evident that the structure we have in place is a very efficient structure. And the termination provisions are probably the most important. They're very user friendly. They can be terminated at any time for, I believe, a one-time fee. So they're not punitive and I think, historically, going back, all the management contracts were extremely punitive and acted as a control feature to prohibit the sale of the company. Ours does not do that.

So we think that the management agreement that exists is still extremely favorable on an expense basis. It's somewhat a breakeven analysis, but in terms of being variable and being able to leverage off the franchise, it works very well. With that said, we think that, and management is going to evaluate, the existing management agreement and see if, based on the way the market has changed since it was put into place, whether there are appropriate amendments to put in place that would probably reflect market conditions more appropriately. And that's something that we'll look at over the next three to six months, to see how all of that works. So that's kind of the story.

Got it. That's a very useful answer. Thank you very much. Second question. You guys have issued trust preferred very effectively and been very efficient with your comments. Do you have a sense of where you are in terms of whether you've got capacity to issue more trust preferred, particularly in light of the buyback?

I believe that that -- the capacity to issue trust preferred has to do with the marketplace, and we always took a little bit of a different position. We always viewed it as equity and we always viewed it as very favorable. Initially, when trust preferreds came out, people would say, oh, you can only have it as 5% of your equity, then 10%, then 20%.

Our view was we'll keep issuing them to the extent the market will absorb them and we believe they're extremely beneficial and since our last issuance, I believe the market has changed quite a bit and if you went to issue them today, I don't think there's a market for them, but that can change. We're very comfortable with where we are. If the market opens up, we'll reevaluate it at that time, but the market is not active on the trust preferred side at this point in time.

Got it. And then, last quest, probably for Paul, the $700,000 that you'll have to make up at some point, is that made up over the maturity of the trust preferred in question or is that something that comes back pretty quickly and we should be thinking about?

I think right now, Don, the way it works is it's based on the swap contract. The swap contract has 3.5 years remaining on it. It was a five-year swap. All things being equal, if the forward LIBOR curves don't change, that should be amortized back into expense quite ratably over the life, but if forward yield curves change, the mark to market of that swap may move and you may see some additional expenses or less expenses in certain quarters.

So it's tough to predict right now, but based on where the forward LIBOR curves are right now, I don't see there being a material adjustment to any one quarter. It's probably going to be pretty ratable.

And you'd let us know if there was a material change in a particular quarter?

Okay, appreciate it. Thank you very much.

[OPERATOR INSTRUCTIONS]

And your next comes from the line of Steve DeLaney with Flagstone Securities. Please proceed.

Hello?

Yes, Steve.

Oh, yes, hey, guys. Good to be back with you after a few quarters off. Ivan, I wondered, because I am cold on this and I think it's an important part of your portfolio, could you just give us a general update on how you see the kind of conversion market in Manhattan? And are we looking at the four properties that are disclosed in your equity participations? Kind of let us get a feel for what that concentration would look like and how you feel about the marketplace?

If you want, Steve, I'll answer the second part of the question, first --

Sure.

-- which is what our condo concentration is, and then I'll let Ivan talk to the market. Currently, as of September 30th, we have 23% of our portfolio in condo concentration, 15% of that is in the New Yorkmetropolitan area, obviously the biggest one being the [Toy] Center and we do have some others in the New York area. Five percent of that condo concentration is in Florida and 2% is in Pennsylvania and 1% in Hawaii and I think I'll let Ivan speak to the market.

Thank you.

Clearly, it's no surprise that the Manhattan market is soft. We went through a period of time when the demand outstripped supply and now you have supply outstripping demand. It's very basic. But Manhattan still is a very supply-constrained market and over time it will be absorbed.

The focus right now is there's still a lot of new projects coming on, but the projects in prime locations are doing extremely well. What we've always paid a tremendous amount of attention to is structure and cost basis.

Right.

And execution -- those are still the key parameters. I always used to say, you can have the best piece of real estate. You can pay too much or have a poorly structured loan and you're going to lose money. And we've been talking for a long period of time now about the condo market and where we are and we've paid more attention to structure and cost basis and location probably than anybody in the marketplace.

So, from our own portfolio, we're very, very comfortable. We feel we have good sponsors, good locations and extremely good structure, and that structure is critical. And we've always talked about interest reserves and replenishment guarantees, because what we've had happen over the last year to two years is a rise in LIBOR. Most of these are floating-rate loans, so you have to have the ability to replenish the interest reserve and have the sponsorship to do it. And all our loans have that capability and, in fact, most of our loans we've had to go back to the sponsors to add more interest coverage, because LIBOR has gone up and we've been very successful with that.

The second piece is that if -- these are still good pieces of real estate. It's a matter of marketing time. When the supply and demand is out of balance, things will take longer to market. And, to do that, you need to carry these projects, and we've built those [inaudible] our projects, and instead of taking 12 months or six months, they're going to take 24, 36 or 48 months. We really don't care. It's going to take longer to execute these projects, and that's what we're seeing, a much longer execution time.

Ivan, when you initially introduced the Toy Buildingproject, I recalled that you indicated that your cost that you were in at was something in the neighborhood of 60 to 70% of what the retail value of the property was projected to be at at that time. Is that an accurate recollection?

Of the sellout price?

Yes.

I don't remember the exact numbers, but what we did is we discounted where the market was 30% to a 30% discount to current market to where we would sell the units to and underwrite the units to, and even with that discount we had a significant spread between our cost basis and that discount to sales price.

I got you. When you considered your extension of credit, you haircut what the developer was saying by 30% as far as the end buyer price.

That's correct. I believe the market was 1,400 to 1,500 a foot and we underwrote it, like, at 1,100 a foot.

We underwrote an 1,100 to 1,200 foot range, Steve, and if memory serves correct our cost basis was about 850 a foot.

Eighty-fifty cost. Guys, thank you so much.

And your next question is from the line of James Shanahan with Wachovia.

Thanks. Related to the last question, I seem to recall a number closer to 700 million for the Toy Building. That included your purchase price, which was in the low 300s and all the costs associated with converting and marketing the property?

Yes, we were given -- what Paul quoted was a cost per foot, according to total price.

I see. I have a question about the CDO, potential timing here, and I'm looking at the cost of funds and I'm wondering what you think the financing impact might be, as well as the size of the CDO.

Right now, Jim, it's tough for us to talk about timing and size because we're really in a quiet period related to the CDO. I don't know what more perspective we can give you than that, because we're really not at liberty to talk about the size or the pricing at this point.

Now, let me ask the question differently. I'm looking at your financing cost relative to some of your peers. Some of your peers, most are CDO issuers, one a senior unsecured debt issuer. They've been a lot more aggressive, trying to manage their funding costs lower, refinancing, extending debt if necessary, being very aggressive in the use of CDO financing as a percentage of their total financing. Where do you think your financing costs can go to, given the recent execution of your peers?

Clearly, the spreads on CDO execution are at the tightest levels they've ever been at the present time, so the market is very advantageous. And I believe that the spread today for CDO -- for a similarly situated CDO, compared to where it was two years ago when we issued our first CDO, is probably 75 basis points tighter, so that gives you an idea how that market has done.

However, these markets do change overnight, sometimes, so you never know what the final result will be. But, Paul, why don't you talk about how a CDO would impact our financing cost?

I mean, certainly, Jim, if the CDO market right now is 70 to 75 basis points lower or tighter than it was the last time we issued a CDO and assuming we assume a similar size, I think that the CDO could drop our cost significantly going forward from a standpoint of our debt cost.

Okay, and thanks, Paul. And in your remarks, Paul, about the condo conversion exposure, I recall that of that percentage exposure in Florida that one of those loans actually had a near-term scheduled maturity. It may have actually passed.

No, that's correct. It does. The scheduled maturity date on that loan is November 15th. We are expecting that loan to repay in the fourth quarter. It's $20 million out of the 5% we have in Florida, and that will leave us with one remaining asset in Florida from a condo standpoint.

Thanks, and I appreciate the disclosure about the LTV in the portfolio. What is the debt service coverage ratio?

The debt service coverage ratio as of September 30th is 124. It was 124 as of June 30th, if you recall. It hasn't moved. LIBOR hasn't changed, really, from June 30th to September 30th on a spot basis. And, more importantly, I think, as we talked about last time, more of our portfolio is either fixed rate or we're requiring borrowers to purchase interest rate caps. So a good portion of our portfolio is protected from movements in LIBOR anyway, and that's why we're not really seeing much movement in the debt cover.

Excellent. Thank you.

And your next question is from the line of [Steve Renari] of Franklin Advisory Service.

Good morning.

Hi, Steve.

Yes, I was wondering where you stand on the Toy Buildingright now.

On the Toy Building, as you know, there are two buildings -- 1107, which is a small one and the 205th, which is a large one. I believe as of yet today, 1107 has zero tenants left. It's been totally vacated. And on the bigger one, there are a couple of tenants left, not that many. The zoning, as you've heard in prior calls, is completely done. So it's zoned residential.

We're evaluating a couple of strategies right now. We are looking at, believe it or not, on 205th Avenue, potential office tenants. There's been, as you've been reading in the papers, huge rent appreciation and strong demand. When we first took this business over, rents were in the mid 30s for this kind of office. We're being told now and actually being solicited by potential large tenants, that rent could be in the mid 60s. But rents in the mid 60s, the numbers actually work out better here as an office building than as a residential building. So we're actually making that evaluation over the last couple of days and going forward, which would leave us in the position of one building, the smaller one, as a condo and the larger one as an office. But that's something that is being evaluated.

We're still very comfortable with our price point, with the location and the market and it continues to improve every day in terms of that general geographic location. But our progress is right on schedule.

So when do you think you'd start to market?

I don't have the exact time on that. I can get you that information. We would clearly look to move very aggressively on 1107 and do it separately than perhaps the bigger building, as we're evaluating all kind of strategies, given where the market has changed on the office side.

So our strategy is to be very aggressive on 1107, get that to market as quickly as possible. It's really an outstanding building with great floor plates and we think that will go well and evaluate 205th. But I'll get you the exact information in terms of market --

Well, I was just curious. It doesn't have be the day or the month. I'm just not even sure of the timeline at all.

Sure.

Okay, that seems like a pretty substantial change compared to, I guess, last quarter, where we thought demand was so high that you'd need office space for condo.

We're just looking at -- we're looking at 205th in the sense that it may just economically be more profitable to be an office. If you do the numbers and if we can get rent in the 60s, I think the results can be far superior than as a condo, and you don't have the interest carry over the marketing period or the marketing cost. But you also have to notice on office, opposed to residential, is you have a 20% swing in terms of how much you rent. You have a loss factor when it comes to residential of 20% to 24%. So you actually have a tremendous yield. So it becomes more of a numbers issue than anything else.

And I'm just curious, the square footage between the two buildings, roughly?

I believe it's a gross from net issue, and I think it's 1.1million gross and then, if it's residential, you lose 20 to 25%. If it's all office, it's 1.1 million, so that's a big swing. And there's also retail component in there, as well. The retail is very substantial.

The retail on the residential side or --

No, the retail space is retail, for retail use.

And then, 1107, how big is that?

That's those two combined. I believe 1107 is around 300,000 square feet.

Okay, one last one. You were mentioning something in your earlier comments about reevaluating the management agreement.

We are looking -- we're not reevaluating the management agreement. We're looking to see if there are any appropriate amendments to make into the management agreement that reflect the market as we see it today, based on when that management agreement was written.

What, exactly, does that mean?

What it means is that when that management agreement was written, the market it was written to take into consideration, the way loans were originated, the market was being conducted at that time. And we think that the market has changed a little bit and it may be worthwhile to take a look at the management agreement to see if there are any improvements that we can make that can be beneficial to the company.

Okay, so you mean Arbor shareholders could pay less?

That would be -- they're certainly not going to pay more.

Okay, that's what I just wanted to make sure.

They're certainly not going to pay more.

Okay, that's what I care about. Thanks so much, guys.

Okay.

And your next question is from the line of Jon Moran with Cowen & Company.

Thanks for taking my question, guys. Just first, real quick, the loan payoffs of 200-something million was a bit higher than last quarter. I was wondering if you had any sense or if you could provide us with some detail on how much of that was scheduled versus -- sort of scheduled and expected versus early.

Sure, Jon. It's Paul. Eighty million of that 212 million matured on schedule. Another 80 million of that was loans that paid off early due to refinances from stabilization of assets earlier than expected. We also had 30 million pay off from early property sells and then 25 million of that we were able to recapture in our refinance.

Okay, thanks. And then, second -- I'm sorry. Is my line still open?

Yes.

Okay, sorry about that. Secondly, just I know that the fixed-rate stuff is now about 25% of the portfolio. And I might be incorrect here, but as I kind of think back over the last couple of quarters, I think that you guys were targeting kind of 25% to 30% of the total portfolio to be in fixed stuff with some prepay protection and everything. Is that still a good assumption to work off of.

Yes, I think it is. Obviously, it's a portfolio that we'd like to get to 30% in the portfolio of fixed rate. Obviously, as the portfolio grows, you need to originate more fixed-rate loans to increase that percentage quickly. We have been increasing it. Twenty percent of the loans in the nine months have been fixed-rate loans and we have taken it, I think, from 20% at the end of the last year to 25% at the nine months, but it does take time to grow that as the rest of your portfolio is growing, as well.

Okay, great. Thanks a lot, guys.

And at this time, there are no further questions. I would like to turn the call back to the management for closing remarks.

Okay, well, thanks for your time. It was a very favorable quarter for us. We've accomplished a lot of significant objectives and we appreciate your support. Take care.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.