Real Estate Cash Machine, 92% Off!

Arbor Realty Trust (NYSE: ABR) is a poignant example -- one of many these days -- of a company selling for an astonishingly low valuation by almost any reasonable metric. You see, at last check, its was selling at $1.51/share, or about 8% of its book value ($18.25).

Surely, it must be going bankrupt! After all, last quarter's dividend was not paid, while the company asserted that this was acceptable, in concert with its obligation to pay only 90% of its profits to shareholders. (This derives from its status as a REIT.) With about $0.91/share in the bank, relative to a likely dividend payout of $0.24, I would say that this was a prudent capital-preserving manoeuver.

They also have $2.7B in debt. At first glance, this company is in serious trouble.

But look again. They have over $3.1B in assets (resulting in positive book value) and are still profitable, having produced $0.10/share inQ32008. Yes, this is massively lower than the $1.02 they raked in in Q32007. However, this would annualize to $0.40/year, which at the last traded price, would put their P/E ratio under 4!

If you're not familiar, the longterm average P/E of the S&P 500 index is around 13. So by comparison, Arbor is vastly cheaper. I might add that the price/book ratio of this same index has averaged somewhere around 2 for the last several decades, versus zero point zero eight!

What's wrong here? How could even the most vaguely fair market mistreat a profitable company so harshly? Granted, the company might be lying about its numbers, but considering the amount of enforcement in the markets these days (which is probably beyond the point of cost-effectiveness), this seems unlikely. The key, I think, is their gratuitous use of leverage.

Specifically, they have about $3.1B in assets and $2.7B in liabilities. In other words, if the $3.1B in assets (mostly commercial real estate, apartment complexes, and the like) were to drop by just $400M, the common stock would be worth zero (ignoring bogus assets such as goodwill and some copy machines). That's only about a 13% drop, which, given the layoff rate in the US job market, seems entirely plausible.

However, by the same token, if the company can survive, then the opposite could occur, which is that a small change in their asset value could result in a massive change in their book value. With $0.92/share in the bank, they have some time to sell their underperforming assets, and streamline their operations, before they succumb to this recession. (I talk as if they're losing money, but at this point, they are still profitable.) And realistically, they could also meet their loan payments for a while by selling assets.

But then there's the horrible property market, with commercial real estate slowly following in the footsteps of the residential market's implosion. No doubt, rents will drop, and therefore, so too the values of commercial properties. This won't happen everywhere in America, but I suspect it will be the rule in 2009. So logically, the fear is that this company won't have a positive net worth for long, hence its cheap valuation.

Again, I think this is shortsighted linear thinking. You see, the banks have learned from the residential mess. They learned that, when everyone is selling a certain asset, it's better to allow a borrower to struggle to pay the debt, than to repossess the collateral (a home, or in this case, an office building or apartment complex), and try to sell it into a hopelessly depressed market. This principle is even more relevant to commercial real estate, wherein the landlord is usually an expert on renting to local businesses. If they can't rent it out, and other landlords in the area are suffering similarly, then why should the bank attempt to liquidate the property at an unattractive valuation? It's one thing if a particular mall fails due to mismanagement. But this is a bankruptcy-rife environment, which encourages creditors to negotiate with landlords in order to facilitate longterm debt and interest repayment. For this reason, despite potential weakness in their portfolio, I think that Arbor will not suffer as much cashflow impairment as shareholders might be predicting.

Still, I never put much stock in book value. After all, in a fire sale (which is when book value is most important), assets sell at massive discounts relative to "new and unused" value. Instead, I tend to look at dividends, as even earnings are often mere accounting concoctions. I believe, from their past payments and ostensible financial stability, that this company will be able to pay out $1/year again in the future, perhaps as soon as 2010. If you keep this stock in your IRA, you'll avoid nasty ordinary income taxes on the payments, achieving a dividend rate of about 66% based on the last traded price. With S&P 500 dividends averaging about 4% historically, this would represent a slight improvement.

So surely I must have bought the stock? No, but I almost did. At the last moment, I found an even more obscenely undervalued little gem. I'm not sure if I should publicly disclose my own holdings. While I consider this matter, best of luck with ABR. Warren Buffet would hate it, considering their apparent addiction to leverage. Still, it's late in the real estate crash, and they still have substantial cash and asset reserves relative to the volatility of their earnings, which means that they can probably survive a few more years of austerity. I think, at a certain point, leverage is sufficiently likely to create a titantic return, and sufficiently unlikely to collapse, that if one were to create a portfolio of such ventures, could sustainably outperform the less leveraged market. If you make a fortune, then please tell them to rent me some cheap office space for my research team!