Safehold Inc. (SAFE) Earnings Call Transcript & Summary

It's Richard Hill again, head of U.S. commercial real estate at Morgan Stanley. I'm really excited about our second to last panel, call it Bottoms Up & Tops Down: A Holistic View of Commercial Real Estate. I think we have 3 very insightful and industry leaders to discuss their views from coast to coast across the United States. Before I turn it over to them to introduce themselves as you've heard many times today, a quick disclaimer. Please note that this is -- that this webcast is for Morgan Stanley clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So with that, John Kilroy, maybe I can turn it over to you just to quickly introduce yourself and Kilroy.

Okay. Thanks, Rich. John Kilroy, I'm the Chairman and CEO of Kilroy Realty Corporation. We're primarily in office, but also life science and then limited retail and apartments on the West Coast, San Diego, San Francisco, Seattle and Los Angeles.

Great. Jay, do you want to introduce yourself and Safehold?

Thanks, Rich. Jay Sugarman, I'm Chairman and CEO of Safehold and iStar. Safehold is the first publicly-traded, nationally-scaled company in the ground lease sector, really reinventing a business that has been a little bit of a black sheep, but we think is very much going to be part of real estate's future.

Great. And Jake?

Hi, I'm John Jacobsson. But as you might be able to see on this commune, everyone calls me Jake. I'm with Related Companies based in New York and in charge of capital markets. Related is a nationwide developer of mixed use, multifamily, office, retail, hotel properties and we're also active in London.

Great. So John, maybe I can start with you. One of the recurrings and one of the themes that's been throughout the conference today is chatter and speculation about work-from-home and if this is going to be a new paradigm. You're obviously focused on the West Coast, and I think there's various different views. But what are you seeing and hearing with boots on the ground?

Yes. That's a good question. There is a lot of chatter. And while we think workplace flexibility will become more commonplace, we think it's work from -- with the office, not in place to the office. And we do spend a lot of time working with our primarily big tech companies, talking to them about what they're thinking is towards the future of the office space. First, it's reintegration of workforce. That will come in over the next several months and segments. And then it's what are they looking for? So they have their own protocols, and I think what's going to happen here is the trend that had already been established, transformation office space that really has been going on for the last 10 years. It's just simply going to be accelerated by COVID. Bigger floor plates; better mechanical systems; more outside air; more security with regard to how things enter the building whether it's people, packages, scanning; all of these different things and a controlled -- the tenants pick, the tenants want to have, with regard to their space, all common space outside space that they control. So office space, that's generally ripped up, ex terraces and so forth. So that's the trend that I think we're going to see. And I think it's going to be a situation where the obsolescence of older buildings, which has been going on for some period of time, is simply going to be accelerated.

And so Jay, maybe I can turn it to you with a focus on the East Coast and specifically New York City. Are you seeing similar trends? Or are they a little bit different on the East Coast? So maybe a compare and contrast to John's comments.

I think that's for Jake, right?

Jake, yes.

Sorry, I heard Jay. Sorry.

No, I'm sorry. I'm sorry, Jake. If there was a -- I would have to be clear on the Jay versus Jake.

Sorry about that.

Jake, can you compare to contrast John's comments, that would be really helpful.

I agree, basically, with everything he said. I mean I think the idea of workplace flexibility is probably a social benefit that comes out of this that's a real positive. It's the silver lining of the crisis. On the other hand, I think -- this is not my original thought, but when I've heard it said that CEOs have never been more productive. But that the younger generation, new employees, people who need to learn and who need to be acculturated in organizations are having a very, very challenging time. And not just because they're not collaborating and they're not working with other people because they may have inferior workspaces in which to do their business, they may not have a large apartment with multiple rooms or a large house. They may be sharing space with a roommate. So there's a lot of people out in the workforce who have continued working and have worked from home and are either secretly or not so secretly dying to get back into the office. Now what we found is that we have tenants who are -- who we are currently building buildings for, or building space for, or we've recently delivered bed space to. And we have found that there is an awakening about the benefits of new office as John said. One of the other things I would add to the list you already gave is things like elevator technology, where being able to run destination dispatch elevators, either off the palm of your hand by swiping it or off of your phone itself, are things that tenants are going to demand. And it's much easier to incorporate in a high-tech modern building than it is in a 60-year-old office building in Manhattan. So those retrofits are going to have to happen. They're going to be demanded by the tenants. And the only other thing I would say is this is a story that will take a long time to be written. There are already tenants who have come to us and said they may in fact need more space because they had spent the last 5 or 6 years densifying, and now they want to spread out again.

Yes. That's helpful. And Jay Sugarman, I'm specifically going to refer to you by your full name, just to differentiate Jay and Jake going forward. You have a unique perspective focused on ground leases. And what I heard Jake and John both talk about what was sort of newer buildings. So can you just talk about what you're seeing for the people that are undertaking ground leases and how you select a good building, whether it be an office property or otherwise?

Yes. Sure. So we get the -- a fairly unique perspective in that we get to think about decades and centuries, not quarters and annual sort of changes. And the old saw about real estate being location, location, location, is absolutely correct for somebody who's making a long-term investment in a piece of land. So we focus on the top 30 markets. The idea of top-down and bottom-up for us is bottom-up is find locations with transportation, economic activity, good, solid infill locations. And then the top-down piece, which is really the benefit of our kind of business, is all the smart real estate entrepreneurs who are constantly trying to increase the value of whatever is on top of that land. So we're much more focused on sort of the dynamics over long periods of time. Where is economic activity going to take place? And then in trust, the future relate to the brilliant developers and redevelopers in the real estate world to look at that future and continually find ways to meet it. So as you hear sort of Jake and John, things are always going to change. And what you really want is people with both the vision and the capital to be able to adapt, and we are an enabler of that. We think we're providing ultra low-cost capital with no maturities and essentially no covenants to make their job a little bit easier. So it's a great perspective to have when the world is changing. For the most part, we are trying to enable others to affect that change, but our business is kind of 1,000 feet beneath the waves, very quiet, very still and very safe. And that gives us a chance to really scale a business without having to worry about what's going to happen next week or next month or next quarter.

Yes. So just building upon something, Jay Sugarman said, John, as you -- I'm sure you're having a lot of discussions with tenants right now. But as tenants rethink their needs, what does it translate into the type of space they want? What are you hearing? What are their big concerns?

Yes. We're not hearing anything about high-density offices or densification of offices, meaning more office -- private offices. It will typically be glass partitions, higher, and we're hearing about square footage going from roughly 150 square feet per person, to 250 to 300 square feet per person. And so back to what Jake was saying, there's undoubtedly going to be some of those who are going to continue to work from home. And that's a great way for companies to be able to sort of have flexibility, but there is also going to be a requirement to have more space in order to de-densify. In terms of the physicality of space, what he said about elevators and so forth is absolutely true. We're doing that right now. I think we're also going to see incredible different protocols with regard to cleaning techniques and the way people access buildings and get through the elevator systems and so forth. And it's not just during this COVID environment because people are thinking about, hey, there's been 19 of these things -- these novel coronaviruses. There's likely to be more, and we need to be prepared. And I think the way the bigger floor plate issue comes along because there'll be communities on the floors, where there'll be, the services typically down the spine now, and then perimeter areas that will be created that will be pods, if you will, on a floor. The big challenge that all these big tenants are going to have is food service because that's become something that they give away. They basically provide breakfast, lunch and dinner as part of the culture, and that is a tough one because the buffet is gone. So there's a lot of studies happening right now with regard to how food comes into the building, how it gets distributed to people, other things we've been talking about.

Yes. And so Jake, turning back to you, all of this sounds like it's going to require a lot more CapEx into office space than maybe what we've seen in the past. Do you think that's a fair characterization? And what does that mean about the positioning of properties? Is it really the highest-quality properties in the best more -- locations, winner take all? Or do you think there's an opportunity to maybe buy distressed and middle- or lower-quality office properties?

Our observation since we started building Hudson Yards, the first office building started in late 2012. Our observation from the leasing side and from frankly being a service provider to our tenants, was that there was an advantage to modern office space; that the light and air, higher floor, floor plates, more technology, those are all things that for a variety of reasons, companies are looking for. And so we think this just underscores that, the modern Class A office space has an advantage. And in terms of needing more CapEx, I mean, I think we would have argued back before the crisis that for New York City -- New York City is the prime example in the U.S. that there is a large supply of office space that's 50, 60, 70 years old, that just is part of the natural evolution of the real estate that Jay was talking about is going to have to be retrofit. It can be and it will cost money. And frankly for spaces that haven't been retrofit today, at least those owners now know some of the things that will be required, not just from -- not just because one tenant asked for it. Because it's, frankly, it's what the world demands now.

Rich, can I make a comment to that?

Please.

Yes. I think one of the problems with the older buildings is they were designed for very low densities. And they were designed frequently with how do you reduce the initial costs as much as possible. So frequently, elevator lobbies were narrow, stairways were narrow, elevators were smaller. And we bought a bunch of buildings over the years and retrofitted them. And a lot of the older stock that is what I just described, is going to be very difficult to fit up for the modern user, just because of their physical characteristics don't comply with the protocols that people have been putting in place for some time and now have been accelerated by COVID.

That's helpful. Hey Jay, Jay Sugarman. It sounds like both John and Jake are talking about a -- for a lack of a better term, where there needs to be more redevelopment. Are you seeing -- I guess what I'm ultimately going to ask is, are you seeing owners of real estate want to ground lease, enter into a ground lease to unlock that value, so they can actually focus on the core real estate rather than the land under it? How -- what are you seeing from your perspective?

Yes. I mean it's funny from our sort of long-life perspective, all real estate is in a constant state of redevelopment. So there is no static operator who isn't going to get trampled by his competitors. So we're, again, looking for an ability to create a new kind of ground lease that really harnesses that entrepreneurial vision as opposed to constraints it the way the old ground lease model typically did. Our view in many of the markets, we're in the top 30 markets is when we sit in the land. And we've got a 5- or 10-story building on that land. We expect over time that somebody will find the highest and best use of that and it may not be its current use. It may not be its current envelope. We've worked with John in California on a project that he completely reinvested and probably added $0.5 billion of value. So our job is really to look at these locusts of economic activity, understand that the world is never static, recognize that we're not the experts, that the building owners are the ones who are really going to create that value and come up with a modern ground lease that actually meets their needs, creates a really efficient capital source for them, and tries to take out a lot of the obstruction or uncertainty that really hinders the real estate world from getting the benefit that the corporate world has been doing sale-leasebacks for decades to unlock the value of the operating business from the lower-return passive real estate business. Well, real estate is the same. The building owner is an operating business, managing, design and leasing. As you hear, there's a lot of active thought and active skill sets. And the land is basically a 99-year bond. And why you have to raise capital and invest it simultaneously into these 2 different investments never made sense to us. But it wasn't until a couple of years ago, we finally figured out how to provide our customers, the $7 trillion of commercial real estate owners, with a modern sophisticated counterparty, nationally scaled, who sits across the table from them and tries to unlock value as you said; as opposed to being a landowner who says, "Oh, you want to build on my land here. My terms, take them or leave them." And that is a fundamental sort of reinvention that we think can change real estate ownership to look a lot more like corporate ownership, separate the skill sets, separate the investments. Let investors make the choice. And some really good things happened for both the building owner from that and also for us as a rapidly growing landowner.

Yes. Hey, John, we're getting a question on the webcast for you. And it really centered from around how office owners should think about the future and what that means for the redevelopment of your portfolio?

Well, I learned a long time ago that, I agree with most of what Jay said, real estate is going to change all the time. But I think what we're doing constantly is assessing which of the buildings that we own may not make it as long as we'd like to own them. In other words, they're not going to perform as well. And so I always struck with physicality, being on location, which obviously is important. But I start with physicality. And if you have a building that physically, you can spend money on to fix up systems and all the rest, but still the physicality of the building is not what people really want, it's still off the mark. My attitude is to sell it and redeploy it into newer buildings or build new or buildings. Not all old buildings are bad. I mean I thought the Gallo sausage, the Gallon Wine family, their sausage-making facility, there was a 3-story building on Grand Street in San Francisco, and I think it gets the highest rents. I'll convert it into a 3-story office buildings. So -- but the characteristics that I think are really important to focus on right now are, how are lobbies going to have to change? How does your mechanical systems comply with not only things like the COVID, but ESG? I mean the reality is Kilroy made a decision 8, 9 years ago to become a leader in sustainability. We've been the North American leader in sustainability against all real estate companies for 8 years going. We're the first one to do 2020 carbon neutral. These are the things you got to focus on, not just where we're at today, but where things are going. That whole thing about where the hockey puck is going? Well, where it's going is bigger floor plates, fewer elevator stops, controlled elevators and entry points where you don't have to touch anything. It will probably become the point where we just think about it, it will happen. That's a ways off, I'm sure. But if you have buildings that don't have the kind of ceiling height, the floor space and so forth that the modern tenant wants, then I think you're just behind the 8-ball and it just gets worse.

That's -- I personally couldn't agree more. Hey, Jake, a question is coming in for you over the webcast, specific to I guess we -- co-working. Our final panel of the day is on Co-working and Co-Living. So I'm curious on your views. But the question specifically is, how do you see shared office space like WeWork changing after this crisis? Could you maybe comment on that specific to New York?

Look, WeWork became one of the biggest, if not the biggest tenant in New York City over its rapid rise. And I think we took an approach that said the concept works. Maybe the valuation isn't entirely correct at any given time, but the concept works. And I think what they provide -- they're providing a service well. They're providing flexibility to office users, large and small. And they're managing the footprint to provide that flexibility. So I think if they can be smart about all the real estate that they control and adapt it, just like we're talking about adapting individual buildings, adapting the spaces that they control predominantly through leases, to accommodate the needs of tenants, then I think they'll do well and they'll thrive in an environment that's trying to figure out how space should be used.

Yes. That's -- I very much agree with that. I think the co-working concept taught us a lot about flexible leases, flexible space, and there's some great lessons learned from it. Hey Jay, taking a bigger longer-term picture or perspective, how do you think real estate will adapt post-COVID-19? And do you see there's any megatrends? Or is still -- is this still all about location as you mentioned previously?

Look, I -- there's definitely change happening. I think racial and gender equality, I think COVID, I think the #MeToo movement, these are all sort of, I think, in my mind, really pointing towards a different future, and one I certainly hope is progressive and better than what was before. And real estate will have to be part of that solution going forward. We have the land under the first new office building on Park Avenue in 50 years. And we have the land under a downtown building that's been in downtown for 120 years. So we see how the society changes and cities change, but we're big believers in New York. We think the city has weathered major catastrophes in the past. And what you need to do and what leadership needs to do is unleash the better instincts and the creative potential of their business community to really help be part of the solution. And I think we've got a pretty loud call now for business leaders to be part of a solution across a number of major issues. You can hear how the real estate piece of it, but I think we all sit in privileged seats to be able to make an impact. And as we think about megatrends, yes, telehealth, and yes to video communication, but I think this is more of a moment for societal changes. And I would say the big megatrends coming out of this is just a bit of a wake-up call across a lot of different social issues that we're all going to have to put on our shoulder to solve. It's -- we've all tried to do things, I'm sure, on a small scale. But it's clear the challenges are in a much larger scale, and we're going to have to take a leading role and figure out how to bring that same ingenuity that we use in the real estate world to really help this next stage of society be better than where it's been. And I think that's the change that I'm most excited about, but I also realize it's a really difficult one. It's one that in our world we think about, but we haven't come up with any sort of game-breaking or game-changing solutions, and I think the world demands it right now. So I think other than the things I'm sure you've heard on your panel today about travel and hospitality being impacted by what we've all learned sitting in our offices for 90 days at home, is definitely going to change things. But I think it will prove to be a small change compared to what potentially can happen if we can all rally to a future that will look a lot better than the one that maybe we thought existed 3 months ago.

Yes. Very insightful. Jay, maybe a little bit of a myopic question coming across the webcast, but I think an interesting one nonetheless. Can you maybe talk about the ground leases that you're actually structuring? Are they 100-year with no breakup options? I think you give a lot of flexibility to the owners of the real estate. Can you walk through sort of how you structure a ground lease?

Yes. I think one of the big breakthroughs here was to change the old-fashioned ground lease structurally, but also to change the mentality. We've been serving customers in the corporate and private real estate market for almost 30 years. And that customer-first focus of what do they need to succeed in their business really was the foundational change that we saw needed in ground leases. So these are -- this is long-term 99-year capital. It's low cost, is essentially covenant-free. It has no maturity. It lowers your debt risk. And it really increases returns, we think, 300 to 500 basis points for most owners who think in 5-, 10-, 15-year time frames. It's just a better mousetrap, and our job now is to educate folks on why this is such a natural part of the corporate world and such an unnatural sort of bias against it in the real estate world. We're still in the first inning, but what we've tried to do is really take that, the entire ground lease ecosystem and flip it on its head from, "I own the land and you'll do what I say," to putting ourselves in the shoes of our customer, the building owner and saying, "What do you need to unlock higher returns with less risk? And how can we deliver that to you? How can we access cheap-enough capital? How can we give you long-enough capital so that we're giving you something that's actually better?" And I think the breakthrough that's hopefully going to happen here and will be at the spear of it is people are going to start to realize that unlike every other capital market area, real estate is still kind of forcing investors to buy 2 different investments that don't belong together, that are inefficient. And if there's one thing that we've learned over 30 years, it's the market's drive towards efficiency. You're not allowed to be inefficient with capital. You're not allowed to be inefficient with your expense structure. You're not allowed to be inefficient with taking extra risk. So we think we've got a product that solves all 3 of those things. It lowers risk. It eliminates unnecessary costs and allows you to be much more efficient with your capital. It's going to take a while to overcome the biases, but it's hard for us not to believe that a better mousetrap, a more efficient capital is not going to find a home in a lot of places. And look, the top 30 markets are $7 trillion of commercial real estate. In the country, we think there's about $100 billion of ground leases. I would say $95 billion of them are old-fashioned and broken. So there's a $6.995 trillion opportunity, and we're the first and only company focused on it, but I can't believe this isn't going to become a much bigger part of our real estate world somewhere down the road. So we're just the leaders, but we expect others to follow at some point.

Yes. Thank you for that. Hey, John and Jake, we have about 5 minutes left. And there is a question on the webcast that is maybe intentionally provocative, but not in a bad way. There's obviously all these discussions about megatrends coming out after COVID-19. But if we get a vaccine next year, don't all those concerns disappear and it's just considered a waste of capital to come -- to build these new and improved office buildings? So again, maybe intentionally provocative, but John, how do you think about that?

Well, I think that COVID, as I said earlier, that is simply accelerating the trends that were already occurring in our industry. And I don't -- while there are protocols with regard to scanning and so forth, that are the way people are going to operate during this period. As I said before, there have been 19 of these things. This has been the worst, certainly the worst in the United States and the global economy. People are much more aware now about health and making sure the workforce stays healthy. So I'm not sure that the vaccine drives that thinking away. This is defined. I think every business is clear, certainly every CEO is clear in seeing how the best-laid plans, the best financial statement, the best marketing strategies, can all go out the window when you have something like this. And your workforce -- and most of these tech companies and so forth, life science companies, the most important asset they have are their people. And they're going to be focused on how they make their people more productive, how they make their people feel more comfortable, how the workplace experience is better. And I'm longing for the day when people operate much more normally, but I don't think it returns to we never had this.

Yes. I agree with John, that everybody will be happy, will be thrilled when there's a vaccine and there's efficacious treatment and you won't have to limit how many people are in a given elevator, let's say. On the other hand, nobody is going to want to return to old-fashioned elevators. And the other thing I'll mention is there have been so many things in our lifetime that have changed and really became permanent changes, even after the reason for it seems to dissipate somewhat. So it used to be when I was a very little kid, you didn't go through a metal detector at the airport. Now after the '70s and the 80s and then of course the attacks in 2001, things have changed permanently. They're never going back. And so I think that's also true in our industry.

Well, gentlemen, we're running up on our 35 minutes. This has been great. I appreciate the back-and-forth dialogue. So I'm going to stop it there. To the extent that there's any questions, additional questions from the webcast, please feel free to reach out to me directly, Richard Hill, and I'll certainly get them answered. But Jay, Jake and John, I appreciate your partnership. I appreciate your willingness to spend 35 minutes with us this afternoon. And thank you very much for your insights and your leadership.

Thanks, Rich.

Thank you, Rich.

Great to be on. Good to see you guys.

Yes. Thanks, guys. And for anyone that's dialing into our next and final webcast of the day, make sure you log in to that specific panel. Thanks, guys. We'll chat soon.