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Arlington Asset Investment Corp (NYSE:AAIC)
Q3 2021 Earnings Call
Nov 10, 2021, 10:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning. I'd like to welcome everyone to the Arlington Asset Third Quarter 2021 Earnings Call. [ Operator Instructions]
I would now like to turn the conference over to Ben Strickler. Mr. Strickler, you may begin.
Ben Strickler -- Vice President, Chief Accounting Officer and Controller
Thank you very much and good morning. This is Ben Strickler, Chief Accounting Officer at Arlington Asset.
Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.
These forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's Annual Report on Form 10-K and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC and you should read and understand these risks when evaluating any forward-looking statement.
I would now like to turn the call over to Rock Tonkel for his remarks.
J. Rock Tonkel -- President and Chief Executive Officer
Thank you, Ben. Good morning and welcome to the third quarter 2021 earnings call for Arlington Asset. Also joining us on the call today is John Murray, our Portfolio Manager.
Beginning last year, the company initiated a process of identifying and evaluating various investment strategies that complement its historical focus of levered agency mortgage investing and leverage the company's historic expertise in the mortgage, housing and structured products sectors. The company's primary objective was to establish platforms or partnerships that provide the pathway to deploy capital into less commoditized investments with high barriers of entry that offer attractive, unlevered returns and also provide the opportunity to use term financing structures where available.
We are pleased to announce that we have made substantial progress toward the execution of this strategy having constructed a unique portfolio of differentiated high return asset classes with compelling growth opportunities in large scale markets, which combined favorable risk return profiles and low leverage. We have successfully established new investment channels over the past year that allow the company to allocate capital in the mortgage servicing rights, single-family residential rental properties, and selective mortgage credit opportunities. These new investment channels should complement the company's existing agency mortgage strategy, diversify risk and improve the level and reliability of returns over time.
We believe the formation of our differentiated investment strategy creates strong building blocks for the company's future growth, profitability and value creation for shareholders. To be able to invest in mortgage servicing rights, the company established a strategic relationship with a licensed GSE-approved servicer that enabled the company to garner the economic return of investment in mortgage servicing rights without holding the requisite license directly.
Under the terms of our partnership that company provides capital to our partner to purchase MSRs directly and the company in turn receives all the economics of the MSRs less a fee payable to our partner. At our option and direction, our partner has the capacity to add leverage to increase potential returns to us. We believe this efficient, cost-effective and lower risk channel for investing in the economics of mortgage servicing rights differentiates Arlington.
The company has grown its MSR portfolio at attractive entry points over the course of the year to 36% of its capital as of September 30. The whack on the company's MSR portfolio is currently under 3%, which is unique in the marketplace, given the portfolio almost has no production before pre-second half 2000. Year-to-date, the company's MSR portfolio has produced high single-digit current cash returns along with asset appreciation through multiple expansion that has resulted in very attractive year-to-date annualized total returns, while employing very modest leverage of 0.1 as of quarter-end.
Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans continue to offer attractive return opportunities while providing a strong complement to agency MBS investment characteristics. At current purchase price multiples of approximately 4 times for current coupon MSRs, unlevered MSR investments offer base returns in the high single-digits.
Turning to levered agency MBS, we're currently seeing available returns in the high single-digits with an appropriate hedge position aided by ongoing low repo costs. However, with the Federal Reserve recent announcement to begin tapering this month, an increased market expectations that the Federal Reserve will begin to raise short-term interest rates next year, the volatility around agency mortgage investing could increase. Against this backdrop and the still historically rich valuations, the company continues to remain cautious about significantly increasing leverage and capital allocation to its levered agency mortgage strategy.
With their complementary characteristics, combining investments in levered agency MBS and MSRs should decrease overall risk while increasing ROE. Mortgage servicing rights tend to increase in value as mortgage rates rise and more specifically when durations on agency MBS extend. This increase in value resulting from mortgage extension typically occurs when mismatches between levered agency MBS and hedges are highest. Furthermore, MSR is offering attractive stand-alone return in the high single-digits and by reducing the need for interest rate swaps as a hedge for agency MBS and their associated costs, MSRs provide a positive carry hedge for levered agency Securities.
Replacing negative carry swaps with positive carry MSRs turns the largest drag on levered agency MBS returns in the current environment into a carry positive. And during the third quarter, the company reduced its negative carry interest rate swap hedge position on its agency MBS investment portfolio as the company increased its positive carry MSR investments, which should improve combined returns going forward without meaningfully changing the company's interest rate risk posture. As of September 30, the company's duration gap of its hedged agency MSR and MBS portfolios was relatively neutral at positive 0.1 years.
After a comprehensive evaluation period, the company is also pleased to announce that during the third quarter, it launched the new investment strategy of acquiring, operating and leasing single-family residential homes. The company believes the investment opportunity in single-family residential rentals offers attractive long-term potential returns supported by favorable supply demand dynamics, a healthy US home financing market and flexible financing structures with attractive returns for institutional investors. We expect the favorable dynamic in US single-family residential homes to continue for some time as we believe the limited supply of new homes will likely not meet the growing demand of housing based on expected demographic and home formation trends.
The company has partnered with a leading global asset manager that is approximately $140 billion of assets under management, including approximately $1.1 billion invested in more than 4,200 single-family residential properties. This relationship will enable us to leverage our partner scale, intellectual capital and access to compelling investment in growth opportunities in the vast single-family residential space. The company has committed to initially invest at least $50 million of capital to acquire approximately $200 million of properties that we expect to lever approximately 3:1.
To finance the purchase of the properties, the company entered into a $150 million five-year secured term debt facility at attractive terms, with a large and highly reputable financial institution. The debt facility has an 18-month draw period of fixed cost of funds of 2.76% with very limited recourse to Arlington. Based on current conditions, the company expects its investments in single-family residential properties to generate current unlevered net yields of 4.5% to 5% and levered yields of 8% to 12%, plus the opportunity to realize home price appreciation on top of that current carry that could push total net returns toward the mid to high-teens.
The company is focusing on high-quality newer homes and is currently active in seven growth markets in the Southeast and the Southwest. As of September 30
Operator
As of September 30, the company had acquired 33 homes for an additional for -- excuse me, for an aggregate purchase price of $9.4 million and that commitments to purchase an additional 75 homes for a total purchase price of $19.9 million. As of November 2, we have acquired or have commitments to acquire a total of 178 homes for an aggregate purchase price of $52.4 million.
The timing of the earnings benefit to the company from investing in SFR rental properties will be dictated by the pace of home purchases, the level of any property level refurbishments necessary and the length of the lease marketing periods. We expect the time period between the date of settlement of the home purchase to the date the house is occupied by the tenant to average between 30 to 60 days. The evolution of the single-family rental market over time has increased liquidity to the asset class through bulk -- potential bulk sales as well as potential enhancements to profitability over time by accessing favorable funding characteristics using structural debt.
Bulk sales can result in lower cap rates than individual home purchases, while securitized debt solutions for single-family rental offer reduced cost of funds and increased leverage based on recent market conditions, driving potential increases over time of 300 to 500 basis points in overall expected ROEs from single-family rental investments going forward. The company also continues to identify and evaluate opportunities in mortgage credit investments that offer high risk-adjusted returns, including residential business purpose loans, commercial mortgages and non-agency MBS. The underlying credit performance of the company's mortgage credit investments produced solid results during the third quarter, supported by a strong economic environment.
Turning to the actual results for the quarter, the company reported book value of $5.97 per share as of September 30, a slight increase from the prior quarter -end. The company continued to operate with overall low leverage and significant financial flexibility with its overall at-risk leverage ratio standing at 1.8-to-1 as of September 30. For the third quarter, the company reported a GAAP net loss of $0.03 per share and core net operating income -- core operating income of$0.06 per share.
During the third quarter, the company continued to return capital to shareholders through accretive stock repurchases by repurchasing 3.3% of its outstanding common stock that accreted $0.07 per share book value. The company has repurchased approximately 16% of total shares outstanding today and as a large remaining authorization from its Board. The company will look to continue to return capital to shareholders by opportunistically repurchasing shares of common stock and highly accretive prices.
This is an exciting time of positive and dynamic growth at Arlington. The company is very encouraged by the progress that is made in the transition to its objective of complementing its core agency MBS portfolio with high return, non-commodity investment channels in mortgage servicing rights, single-family rentals, and mortgage credit.
We have created innovative partnerships and non-commoditized businesses which provide access to scaled high return opportunities. We are active and growing in the MSR and SFR businesses, making Arlington a unique and differentiated platform in the small cap arena. Our new businesses offer attractive double-digit return profiles, well-structured, which currently trade at valuations in the market above book value. We are optimistic about completing our goal of building a differentiated investment platform that should generate higher returns, reduce overall risk and increase earnings power over time that can form the pathway for returning more capital to shareholders in the future.
Operator, I would like to now open the call for questions.
Questions and Answers:
Operator
Thank you. [ Operator Instructions] Our first question comes from Doug Harter with Credit Suisse. Please go ahead.
Doug Harter -- Credit Suisse -- Analyst
Thanks. Rocky, you briefly mentioned this, but can you just talk about your -- the partnership for single-family rental on the operating side, kind of how you plan to kind of operate that? And then, if you could just also remind us of kind of the partnership you have with the sub-servicing on the MSR side.
J. Rock Tonkel -- President and Chief Executive Officer
Sure. Just starting with the servicing side. So, we've got a national servicer that we are partnered with, with a long experience in this -- in that arena. And I think, the capability of that partnership is borne out, to be honest, by the nature of the assets that we've been able to put in place and the performance. We've had a very disciplined process with our partner, works very fluidly. We've had, on those loan pools for which we capture as relevant and our earlier ones is not really relevant yet because we haven't hit the point yet where recaptures are really necessary, but we've had a good recapture experience, and we're optimistic about how that will move forward. And obviously our returns have been very handsome there. And we don't have to absorb either the expense or more importantly, the regulatory burden of actually operating the servicer. So to us that's been a very favorable outcome to-date.
We're very enthusiastic about our partnership in the single-family rental business. This is a global financial institution on both the acquisition, refurbishment, and leasing side as well as on the -- our financial partner on the financing facility, which we think is about as robust as one could find for a non-investment grade company in the space. And our partner is extremely capable and experienced. They've been in the business for at least, if not more than a decade. And as I said in my comments, they own currently, and have owned over time, I suspect many more thousands of homes. But today, they own about 4,000 homes.
We and they work together through third-party property managers and refurbishment entities. And that is -- thus far it's early days, but the early results there are -- appear to be promising with yields thus far at or above our expectations and the pace of our activity on track with our expectations. We wanted to take a bit of a patient approach to acquiring assets so that if there is a little bit of a pullback on the back of the appreciation we've seen in recent periods that we'll get the benefit of that with our new capital going into the space.
We feel like there is really exciting and explosive growth opportunity in that space for us. Honestly, in both of these MSR and the SFR space, we think there are growth extensions off of the partnerships that we have created here that are quite innovative, we believe. And these growth extensions can be very powerful over time. We're already in conversation with different parties about potential growth pathways for us to capture the benefit of more scale in each of these two businesses. So we're very enthusiastic about both our return profiles and MSRs have been in excess of our expectations. And our portfolio is at least as attractive as we expect it to be. We're very pleased with that partnership.
And it's early days on the SFR side, but the same principles apply. Very pleased with the partnership, very accomplished, experienced, responsible, stable, sturdy party in our partner, and as good a financing partner in facility as one could ask for. So we're very pleased on both counts and excited about trying to capture what we think are potentially explosive growth opportunities going forward.
Doug Harter -- Credit Suisse -- Analyst
Appreciate it. Thank you.
Operator
Thank you. [Operator Instruction] Our next question comes from Eric Hagen with BTIG. Please go ahead.
Eric Hagen -- BTIG -- Analyst
Okay. Thanks. Good morning. Maybe just one from me. What do you guys think is the right amount of liquidity and the sources of that liquidity to carriers? You guys move into these new strategies and you're also focused on buying back stock at the same time.
J. Rock Tonkel -- President and Chief Executive Officer
Thanks, Eric. So, as you may know, we've historically carried a very liquid balance sheet. We continue to seek to keep our overall liquidity very high. To-date, that's been accomplished through maintaining low leverage as well as a cross-section of assets that are highly liquid, including, of course, the agency side.
We do expect to continue to have a substantial participation in the agency side. It's the natural pair for the MSRs. And so, obviously that will be -- continue to be a source of capital for us. If you think about the MSR side and I think today, we're just a little above $100 million or so in capital. We've applied very little leverage there and we do have the flexibility to apply more over time, but we're cautious about that on the MSR side, as we have said in the past. In any event, if we've got, call it, a $100 million-ish or a little more over time, I'm just using $100 million or round numbers.
That would apply that we want to have at least, I think, generally, as a general marker, $50 million or so, about half the amount of the MSR capital in an agency loan book. And so, that together that's about half the capital between those two. Obviously the $50 million or so in the agency side is liquid. We maintained a mortgage credit portfolio that has CUSIP securities in it and those generally tend to be liquid.
As we sit here today with the expectation that we'll grow our capital investment in the SFR to something like $50 million, well, then that's going to leave us with solidly in excess of the, call it, $150 million in the agency MSR side and another $50 million in the SFR side. That's going to leave us with somewhere between a third and a half of our capital that's pretty liquid. To the extent that we grow that MSR book or that SFR book a little bit over time, which is possible, I'm not telegraphing that that will happen, but it is certainly possible given the return characteristics in those and the strength of those, the robust partnerships that we've built there, that could extend somewhat. But as we sit here today, somewhere between a third and a half of the balance sheet of our capital is highly liquid.
And that probably comes down a little bit over time. But I would think that we'd probably be trying to keep, give or take, a third of our capital over time to be in a highly liquid form. So we'd have complete flexibility to adapt to new opportunities, to buy the stock, to assess what the best risk return was at any given day and time between an incremental investment in our key strategies and buying the stock and to be prepared with a low leverage approach for rainy days and volatile times when they come into market, try to take advantage of them.
Eric Hagen -- BTIG -- Analyst
Thanks a lot. That's helpful detail. Appreciate it.
Operator
Thank you. Mr. Tonkel and team, there are no further questions in queue at this time.
J. Rock Tonkel -- President and Chief Executive Officer
Okay. Well, thank you very much. We appreciate your time and your thoughts. And if you have follow-up, please feel free to give us a ring. Thank you very much.
Operator
[Operator Closing Remarks]
Duration: 23 minutes
Call participants:
Ben Strickler -- Vice President, Chief Accounting Officer and Controller
J. Rock Tonkel -- President and Chief Executive Officer
Doug Harter -- Credit Suisse -- Analyst
Eric Hagen -- BTIG -- Analyst
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