Safehold Inc. (SAFE) Earnings Call Transcript & Summary

I'm here with Katy McConnell. We're pleased to have with us Safehold and CEO, Jay Sugarman. This session is for Citi clients only, if media or individuals are on the line, please disconnect now. Disclosures are available up on the webcast. For those joining us on the webcast, ask management any questions, simply type into the question box on the screen, and they will come directly to Katy and myself, and we'll do our best to lead those into the conversation. Jay, I'm going to turn it over to you to introduce the company, any of the members of your management team that are with you. And I think you're going to go through some slides to provide the story about Safehold.

Fantastic. Thanks, Michael. And we've got Jason Fooks, Head of IR; and Marcos Alvarado, who's our President and CIO. And let's jump right in. I think some of you know, 4 years ago, Safehold created the modern ground lease industry to unlock significant value for commercial real estate owners around the country and equally importantly to give investors an opportunity to participate in a very valuable asset class that has largely been off limits to them. If you look at Page 3, we could flip to that. Today, we're going to talk about the success we've had to date with that strategy, touch on some of the key drivers of that success and then really focus on the 2 components of value in our ground lease portfolio. And perhaps most importantly, we'll finish telling -- we'll finish up by telling you why the second component appears to be materially undervalued, give some simple ways to see that value and show you why we're excited about Safehold in the future. We're going to talk about the strong financial performance, our strong customer growth. And again, there's very significant value potential. So let's jump right in. What you see on Page 5 is the strong financial performance today. We've posted nice growth in revenue, very strong growth in EPS over the last 3 years. You can see that reflected in our share price performance. Jason always wants me to mention, we were the #1 performing Nareit member stock in 2019 and 2020. And I know you're probably interested more and can we repeat that in 2021, and we'll show you later why we think that might very well be possible. One of the key things investors like about Safehold is very safe nature of ground leases and that certainly helped drive returns. Our ground leases did pay 100% during the downturn. And that's not really surprising if you look at where they sit in the typical real estate capital structure, very much akin to the AAA slice of CMBS. We've had some positive affirmation from Green Street, but these are some of the most safe assets in the entire real estate industry. So let's turn to why the business is growing so strongly. You can see on the left-hand side of Page 9, our portfolio has grown almost 10x, actually, right around 10x over the last 3.5 years. And that's really a function of delivering the lowest cost, longest term, most efficient capital to commercial real estate owners around the country. And we can say that efficiency concept is not just capital efficiency but it runs to cost and to risk reduction, and we show that on Page 10. One easy way to think about what we're doing when we created the industry is really to deliver what net lease does for corporations, we are doing for real estate owners. We are separating the operating business from the passive fixed return asset that most corporations use to run their business. And that most building owners own and don't really realize that the land doesn't affect the same thing. So separating these 2 very different investments, One a active operating business, one a passive long-term cash flow stream business, allows investors to pick and choose which 1 they want. And as we've seen in almost every market in the capital markets, when you make -- when you give capital investors choices, 1 plus 1 equals more than 2. So we think we've significantly unlocked a big inefficiency in the commercial real estate world. We think it eliminates a lot of unnecessary friction costs during the life of a property. And even more importantly, we think it reduces -- materially reduces the maturity risk that a real estate owner faces. If you think about a typical deal, if you're leveraging your property in the private market, 65%, 70%, all of that debt comes due in 5, 7, 10 years. When you use this capital efficiency tool, this modern ground lease tool, you take about half of that maturity risk and virtually eliminate it. And so when we think about real estate and one of the most important risk factors, we think reducing the risk of a large maturity and a weak fundamental market. If we can cut that in half, we're definitely helping owners earn higher returns with less risk.

How do you think about -- just as before we go on, how do you think about encumbering that asset for that owner when they eventually may want to sell going down the road? And thinking about -- if there's mortgage debt, right, that always becomes somewhat just processes and timing of something to get paid off, it may have a cost to it.

Sure.

It's just another encumbrance and I would suspect a ground lease could impact that as well. So how are owners or your customers think about that element?

It's a great question. Before we launched Safehold, we spent about 1.5 years studying this market intensely. As you know, iStar has been a lender and an owner of real estate and net lease provider for almost 30 years. And what we found is the old ground lease industry, unfortunately, was improperly structured and improperly sized and actually did impact the liquidity of the building when owners went to sell. But we also realized there were many cases around the country and around the world where ground leases are a natural mainstream part of the capital stacks. You think about that around hospitals, around universities, in some major markets in the U.S. and certainly in Europe. And it all comes down to finding the optimal place in the capital structure, where you're not impacting the liquidity, you're not impacting the leasehold lender. We think that sweet spot is about 1/3 of the capital stack. We took pressure, tested this on our own portfolio, buying and selling assets. We think we're unlocking significant value when we sit in that relatively safe, relatively quiet part of the capital structure. You can almost think of it like a utility or a tax which has no maturity as opposed to some of the bad and miss -- I would say, miss-sized ground leases that are too big, poorly structured and do impact liquidity. So we're closing in on 100 transactions. We've worked with dozens and dozens of leasehold lenders. We've worked with a number of sponsors in the top 30 markets around the country. I think we found this modern ground lease fits in very naturally and actually doesn't change the economics. In fact, it improves them. Again, we think our business is basically predicated on 1 plus 1 equals more than 2. The building owner gets higher returns with less risk, and we create an asset class that lots of investors want to own but have never had a chance to own before. So we can walk you through -- actually, Page 11 shows you some of the assets we've recently done. Office and multifamily are the 2 top property types in our portfolio. We certainly think there is sufficient liquidity in the leasehold lending world and in the buyer world for these kind of assets, where you guide ground lease that is very quiet, very simple, very standard. And I think we've really created something that will become a mainstream component when people think about capitalizing new properties.

Have any of those 100 assets that you've bought, have any of those been subsequently sold with your ground lease? Or are they still all the borrowers or are they still basically all owned by the lessor?

We've seen capital raised, and that certainly has proven out our thesis. We haven't seen 100% transaction. There were some teed up before COVID. But obviously, with COVID, we'll see them come back to market now.

And then is there -- and all these 100 deals, they're all originated ground leases by you? Or have you bought existing ground leases?

It's about 20-80, 20% were acquired. We have a program called SAFE x SWAP, where we take old poorly structured, poorly sized ground leases and we modernize them. That's going to be about 20% of the business, we think, and the other 80% is newly originated.

Okay. I'll let you continue. Sorry.

Right. It's a good opportunity to talk about what's happening now and why we're so excited about the future. If you go to Page 12, this is, what we think, a $7 trillion addressable market. All the major property types across the top 30 MSAs. We've been playing in those markets for 30 years as a lender, as a provider of capital, as an owner and operator. So we got a very good feel where the good dirt is, where the best land is. We've created the first nationally scaled platform, the first public company to really give investors a chance to invest in an institutional quality, nationally scaled platform that's out there every day, growing this very valuable tool in a very large industry. And I think what you'll see in '21 and '22 is a lot of new innovative growth coming from new products we're developing. As we listen to our customers, as we show them the power of separating the operating business from this passive lower return asset, they're coming back to us with opportunities to expand. So you'll see us work with them. 1 great new piece of the puzzle for us going forward and what we think is a major competitive advantage as we were rated in our debut ratings by Moody's and Fitch at BAA1, BBB+ that gives us a lot of flexibility, a lot of nimbleness to work with our customers on a lot of new areas and, obviously, gives us a lot of firepower. Again, our goal is to be the low-cost, long-term provider of this most efficient capital and these strong ratings give us a real head start on that. So that's how the business has been developing. It's actually gone very much as we thought. We thought it would take a while to educate customers about the differences between modern ground lease and some of the bad ones they've probably seen in their past. It took us a while to really help people understand that customer is the customer. Building owners should benefit from this, make them understand that 1 plus 1 equals more than 2. And now we've turned our attention a little bit more to our investors to share with them why we think this asset class is so powerful, so valuable. And when we see make fortunes for monarchies and hospitals and churches and universities, we're now making it available to all investors. And the easiest way to kind of dig into that valuable nature is to look at the 2 components of value when you build a growing ground lease portfolio. Remember, a ground lease really gives you a rent stream for a long period of time. And then at the end of the lease, you get the ownership of whatever is on top of the land. So 2 very distinct components of value. On Page 14, as you can see on your screen, we can talk to you very simply through how we look at the rent component of a diversified portfolio across the country by product type. And when you put that in a simple chart, what you see, and this is just sort of the generic target that we set for our portfolio, very close to what we're actually doing. You can see that blue line is what a ground lease sitting in a very, very ultra safe part of the capital structure, what it pays year-over-year over year against our original basis. And by comparison, we can also show you something else that's very high-grade, contractual cash flows on a long-term basis. There are a number of very long live bonds. We happen to show MIT here, there's a number of others, all sort of AA, AAA quality. And we went to Green Street and said, compare these 2 things. And I think they came away with the same conclusion we did, which is this is a very good comparison. This is the best comparable for what you're creating on the rent side of your ground lease portfolio at Safehold. Except if you look at that blue line versus the gray line at the bottom, ground leases create a tremendous amount of value over time. And in fact, it's quite simple to do the calculation. If you take all the contractual cash flows discount them by the market benchmark discount rate, it turns out that the portfolio has a significantly more value than just about the investment we've made right now, that calculation is about 1.8x. So all that blue hashmark is the excess value for all the work we've done to create a machine, to help customers do ground leases, unlock value, but it also creates something very special for us. Now let me be clear, the value of a single ground lease is different than the value of a company, creating ground leases. So you need to create that diversity, eliminate that single asset risk. And then your cash flows look a lot like these high-grade long-term bonds. And it's taken us a while to build our portfolio. We're just over $3 billion now to really build that diversity to create that stability, to be able to make this comparison. But I think the market has now started to see, as Green Street did, that this is a very valuable part of the ground lease portfolio we built. I did want to take some time today on the second component. And something we rarely talk about. In, fact, this will be one of the first times we really dig into it. But the second component is equally as important when you think about Safehold and what we think is the long-term potential and upside. It's something we call the unrealized capital appreciation. And as I said before, at the end of the ground lease, typically 99 years, we get whats ever on top of the land. And since we went public, we've been tracking how much is sitting on top of our land. Just today, we're not predicting values going forward. We're just saying, how much is in our portfolio today. And we call that unrealized capital appreciation since we know we're going to own it and we know what it's worth today. We know it's in effect in our accounts. And we've tried to help investors track that really for the last 3.5 years. So that we could show them that this component, which many people overlook or simply don't understand, is actually one of the most valuable parts of what we're building. And we think you can use some very simple tools to evaluate it, to value it, to see how much upside has yet to be reflected in our share price. So it's not surprising. If we go to this next page that investors haven't valued this because we haven't really helped them do so, and they've never seen 1 before. There's never been a dedicated national platform delivering value for commercial real estate owners through modern ground leases. So there's never been anything to compare this to. Yes, we would say you can compare it to lots of other things using the tools we use to evaluate all investments. And what we did on Page 16 is just say, let's do what we do on all investments, which is find its NPV. But we know if we have a starting value, a growth rate and the discount rate, we can value almost any asset. We all learn that right away in our business. And that's really all we need to do here to help give you a sense of what this value could be and what we think it is. Now our lawyers are not going to let us tell you what we think it's worth, but we can show you how to valuate some very simple assumptions. So on Page 17, let's fill in that NPV with some numbers that we think are not very controversial. In fact, in many respects, are quite conservative. We have CBRE go out and value everything sitting on top of our land. That happens every 12 to 24 months. We know today that value is around $5.5 billion. We know the growth rate of that portfolio is comprised of sort of a natural inflation, that's the internal growth rate. We've seen a number of academic studies. Let's say, if you're not upgrading the building, if you're just maintaining it, you should expect about inflation as your natural organic growth rate but we're also creating new ground leases every day. We're also adding additional buildings into that account, into that portfolio. And that's what we call the external growth rate. So those 2 combined, basically, inflation and whatever Safehold's origination growth rate is creates a portfolio growth rate. And then the discount rate, we use what others have said is the appropriate unlevered discount rate for high-quality, diversified institutional portfolios of real estate. And I think, again, if you look at Green Street, you can look at someone at Nareit, that's in the 6%, 6.5%, 7% range. With interest rates down, it's been more closer to 6% in some of the Green Street stuff we've read. So these are really simple. Putting your starting value, we can tell you that. CBRE gives us that. We report it every quarter. Put in your inflation guess, we use 2% because that's what the Cleveland Fed uses for the next 30 years. Put in an external growth rate at Safehold, we're going to use 4% to make the numbers easy. We'll show you where it's actually been. And then putt in your discount rate, which again, we think Green Street and others would tell you on an unlevered basis, a diversified pool of high-quality institutional, real estate should deliver about 6% over a long period of time. And then we can do a simple sensitivity showing different external growth rates at Safehold and different discount rates. And what you see is an asset that, again, if you look at most analyst reports or you ask most investors, they have either been not paying attention to or just simply don't understand how to approach or value versus what we think, which in a company with 54 million shares and asset with these kind of values, obviously, makes up a substantial potential upside.

And how do you think about change of use? 100 year is a long time. I hope we're not sitting to -- well, I guess maybe I do hope we're seeing together at the 21/21 conference. But real estate changes, right, dramatically. And I recognize land value, which is what you're effectively buying. Is the hold into what's on top of it. But what's on top of it is going to change dramatically over, I would say, 10 years, 20 years, 30 years, 40 years. Over that time period, a, just what you said, not investing in the asset, but just change of uses that are out there.

Yes. If I had to boil it down for you, Michael, you hit on the -- probably the most powerful part of our story, which is not just location, location, location, which is the land, but this idea of highest and best use. We've got the entire real estate industry walking by these buildings every day, thinking how can I make it worth more? So when I look out my window in New York, there's very few assets that over long periods of time, and we actually, again, have academic studies on this that haven't increased materially in value. Some of the assets sitting in our own portfolio have increased in value 100-fold over their lives so far. So we're actually harnessing that idea that it doesn't have to be the same building. What we're harnessing is somebody in our industry will figure out how to put the highest and best use on our land over time. And we have every incentive to help them do that. So this unrealized capital appreciation is in effect, a very tangible number. It's exactly what's sitting here today. But you can apply your own ideas around what the value of -- what's on top of our land will grow. We're just using inflation. Obviously, if somebody does a material upgrade to a property or builds a 10-storey apartment building instead of a 2-storey shoe store or a 50-storey office instead of that 10-storey building, that's just adding more value than the 2% inflation we're using. That's actually adding incremental value. So you can use -- 2% is, again, somewhat conservative on the internal growth rate. We can show you certainly in top cities that might prove to be quite conservative. So we've got this very simple math. We've got this very simple concept. It requires us...

Jay, I think your camera flipped around. It looks -- it is a beautiful day in New York City, though. So if you -- but I think you should go back to the other side.

Yes, I should do that, shouldn't I? We're almost finished, so maybe I'll do that again. So here's what we know from that formula. If your portfolio grows at less than the discount rate, and that happens over a long period of time. It's not going to be worth very much, right? And that is unfortunately the case when you own a single residual. You're only going to grow at inflation or inflation plus 1% or 2% if you've got a great sponsor. And your discount rate is going to be an idiosyncratic discount rate. It's not going to be as low as when you have a diversified pool of institutional quality real estate around the country. So the first bullet point really reflects kind of the formula when you have a single asset. That residual is actually not worth a lot on an NPV basis. But when you have a machine that is growing your portfolio, not just from the internal growth, but also growing new buildings from each new ground lease, we said, well, let's make the numbers easy. If it grows at the same rate as the discount rate, then we know the NPV is what it's worth today. We know that $5.5 billion that we get from CBRE and from the spot value of those assets will grow at the same rate as you will discount it, then that's really an easy formula. And then excitingly, if you can grow faster than that formula or faster than that discount rate, the NPV will be significantly higher than today's value. And what we did, Michael, to really sort of sync this with what we're doing is we said, well, what would we have to grow our UCA portfolio at this portfolio of buildings to stay on this 6% chart, not the 10% chart, just the 6% chart. And we have to do about $120 million of ground leases this year $150 million in a year, 5 years from now. We did that all the way out to 2040. And so in 2040, we will need to close $363 million of ground leases, which will create enough new buildings in our account to keep us on this nice, steady 6% path. And we said, by comparison, over the last 2 years, we've averaged about $1.2 billion a year. So 10x more than we need to do this year, that's 4x -- 3 or 4x more than we need to do 20 years from now. So these are very conservative, modest relative to our recent activity. We just got investment grade ratings. So we think we're actually in a stronger, better position to grow. But even if you just look at the last couple of years, historically, we said in our IPO, we think this is going to become a very valuable component. We said we need time to build the diversity. We need time to make the case that we will be growing. But let us show you what we can do. We'll come back to the second component, let's focus on the customer, let's focus on the cash flow. But let's not forget about the second very, very valuable component. We'll track it for you. And if we stay on the 6% curve, then it's worth spot. If we can do better than that, then you can use your own numbers. Well, here's what the 6% curve required us to do, $440 million, $466 million, $494 million, $524 million, $555 million. And here's what we've actually done, $440 million, $950 million, $1.8 billion, $4.8 billion, $5.5 billion. So you can see, at least, historically, we're way ahead of the model we just showed you. Long term, obviously, there'll be competition. Long term, we will get better. We will be more innovative, more customers will understand how to make this tool work. Just as net leases have done for the corporate world, that's a $1 trillion market. This is very analogous for real estate. And we'll just finish by showing you what that looks like visually. Because I think sometimes people think, well, I don't know what this thing I'm going to own way out in the future is worth. But it's really not that hard, just look at what it's worth today and look at what it's growing at. And if you know its value today and you know what it's growing at. And you know what comparable portfolios of real estate or ask to return in form of discount rate, it shouldn't be that complicated for people to start recognizing this value, this very valuable second component of value. Now we have to grow. We use these historical numbers. We're not expecting to continue to grow at 100%. But at 4%, Michael, I think we have good success helping people see this value.

Okay. There was a couple of questions, Jay, that came through the webcast from investors and they're both tied to bond yield. So 1 says, stock seems to trade with bond yields, how do you convince the market you aren't just the bond? And the second one says that the economy reopening to benefit from huge government infusion of capital, low interest rates, are your low yield still compelling for the investor? So it's actually 2 related questions, but different topics.

Yes. So great question. Remember, we have spent most of our time talking about our customers and the cash flow streams. And obviously, long-term contractual cash flows have some negative correlation with interest rates. But the second component we just talked about has positive correlation with interest rates and inflation. So we've always thought this is one of the great long-term hedge businesses. Through thick and thin, it's created massive fortunes for again, monarchies, churches. And then one of the reasons is you have 2 components. It's not just a fixed income stream, albeit it's a great one, and we're creating significantly above market returns by creating this growing diversified portfolio. But we have this other, right now, $5.5 billion asset that is going to benefit from economic activity inflation. That is $5.5 billion of bricks and sticks and concrete and steel and all the other components that is positively correlated. So our stock has traded historically a little bit with interest rates, but it's fundamentally because this is the first time -- and congratulations to you. This is really the first time we've actually laid out the second component. We've said this is the major focus in 2021 because we've reached $5 billion. We've reached the diversification and scale that allows us to show this very, very tangibly as the second large component of value equally as valuable as what's coming in from the rent streams is the fact that we have built a very, very valuable portfolio that we can value for you. We can give you the tools to value. And we can say with some confidence, if you look at most of our analyst reports, very few investors have actually given any credit to.

What's cash flow coverage like for the portfolio, assuming all CapEx on a maintenance perspective, all levels of NOI, and how much spread do you have or do the owners have of -- within there?

The sweet spot is 3 to 5x coverage. If you -- again, this is one of the classic mistakes from the old ground lease world is, if you put too big a ground lease under a building and you eat too much of the cash flow, it's no longer a value creator. It's a value destroyer. And when we did a lot of studies on this, the right spot for it is, again, this 3 to 5x. One of the things we always counsel our customers is, the question is not how much can I get for my ground. It's what is the optimal size of the ground lease to unlock value through the entire capital structure. And we find that to be, again, this 30%, 35%, 40% and 3 to 5x coverage. Those are the optimal places to have this conversation. And typically, we will not go anywhere else. We know when it works, and we know what doesn't work. We've now done this. Again, we're probably at 75 to 80 deals. We're approaching 100 in the pipeline. That gives us great confidence, Michael, that we have figured this out, cracked the code in terms of what the capital markets need to function smoothly. And there's no reason to go anywhere else.

What are the restrictions on behalf of the ground lessor, in terms of additional secured financings on the building? How much do they have split in maintenance every year? I guess what does your structure allow them to do and not to do?

Yes, we try to let them do what they do best. So the minimum number of constraints that seem prudent, we're going to be fine with. We want them to capture the highest and best use. We don't want to tell them what it is. We want them to figure out what it is. And so we've seen it again in a lot of old ground leases if somebody had to do a $10,000 improvement on a $600 million building, they had to go get the ground lease permission. We're never going to try to stand in our customers' way when they're trying to do what they do best, that's the entire premise of our business. So it's low cost capital. It's long term capital, and it's as least restrictive as we can make it and still be prudent.

In terms of structure of the entity, obviously, this was a company that you started out of iStar and iStar still controls the majority of it, externally manages it. How do you think about governance and the go-forward as an independent entity?

Yes. We wanted to make this a pure play. We think it's the first time investors have had a chance to invest in this amazing asset class. And so we wanted to make it really easy for them. So we set it up as a separate company, but we are the largest owner with about 2/3. We're the investment manager. And obviously, we're putting our heart and soul into it, but we think it's really going to become this mainstream part of the commercial real estate world. What we've also said is when Safehold reaches scale, $3 billion, $4 billion, $5 billion, we're starting to feel like we're reaching some of the scale. We will start to have a conversation with iStar about, is there an even better architecture that will unlock more value for both companies. We think that's still a little ways off, but it's certainly -- we crossed some of the first milestones to make that a good smart question. And what I would honestly tell you is we think this is going to be an enormous business. iStar support has helped it get there. But at some point, Safehold is going to have reached a scale where it can have other opportunities to think about what's the best architecture. And I think both Star as its largest shareholder, is very interested in unlocking maximum value. But to date, you've seen them be an enormous buyer of Safehold because this second component value, we don't think that's even been valued yet. And we have always thought, this is an enormous, again, $5-plus billion, over 54 million shares, you can do that math. We think this is the next big catalyst, and we're excited to start sharing with the public shareholders.

When thinking about some of the property sectors and you think about office and retail that are trading at discounts to NAV in the public markets. Is that a bigger opportunity for you to partner with existing public landlords to sort of separate the land from the buildings? Or I don't know if that presents an opportunity for you?

Yes. We think long term, that is going to be an opportunity. I would say the early adopters have been some of the private investors, some very sophisticated private investors, some of our sponsors and some of the largest real estate investors globally. I just think the public doesn't want to have to explain our business. We have to do that first. We've been educating. As you know, it's our first time really to have a chance to talk about this piece of it with your -- the clients. So we've got some more educating to do. But there's no reason, again, how many corporations have done net leases to separate their operating business from their fixed assets? I think we could think of almost every major corporation has taken advantage of that efficiency. We think almost every real estate owner should at least be thinking about, wait a second, I can increase my returns, reduce my maturity risk, avoid unnecessary costs, how can I not at least look at this. And obviously, we think the public companies can benefit. But we'll keep innovating until we find the right products for each part of the market. Right now, you can see multifamily is growing fastest in our book because we took a hard look and said, Here's what they need, and here's how we can meet that need. We'll do the same with public companies eventually.

Okay. Well, we've actually run out of time. It's amazing how fast 35 minutes goes. Jay, we really appreciate you presenting today and have a great rest of the day in a beautiful day in New York City.

Awesome. Thank you so much. Thanks for your time.

See you, Jay. Thank you.