Safehold Inc. (SAFE) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to the 9:45 a.m. session here at Day 3 of Citi's 2022 Global Property CEO Conference. I'm Manny Korchman with Citi Research, and we're pleased to have with us Safe and CEO, Jay Sugarman. This session's for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. If anyone has any questions, throw them into the live QA portal and I'll be sure to ask them during the meeting. With that, Jay, I'll turn it over to you to introduce the company, make any opening comments that you'd like. And then we'll go to Q&A.

Fantastic. Thanks, Manny. Thanks, everybody, for coming today. Safehold is revolutionizing the way real estate in this country is being capitalized. That's a $7 trillion addressable market that we feel is, at this point, completely untapped. We started the business in 2017 using 30 years of experience in the finance and net lease world to figure out why the ground lease business had never become a major part of the real estate capitalization story. We think we've corrected all the ills of the past, all the things that made ground leases a negative connotation in many building owners' minds. We made them simpler. We made them standardized. We made them customer-friendly. They unlock value now in a way that in the past they used to destroy value. And once you do that, suddenly that entire $7 trillion addressable market can now take advantage of a much more efficient form of capital. That idea that land and buildings are 2 separate investments has been expressed in the corporate world for over 20 years. Operating businesses and passive real estate have been separated in the corporate world and have created a $12 trillion industry. We're bringing that same thought process, those same efficiencies to the commercial real estate world, separating the operating business, the building, the managing, leasing, marketing, designing, financing, buying, selling from the passive land position. Ground leases' 99-year instruments have never really been available to investors before, and that's certainly never been a business that could grow. New ground leases could make them so attractive to customers that every quarter the portfolio would grow. You'd be controlling more and more of the top 30 cities in this country. Once you crack the customer code, this becomes an exceptional investment opportunity, and we'll talk more about that in a minute.

Jay, what are the top 3 reasons investors should buy Safehold stock today instead of any other listed property company?

Reason 1 is, as I said, we're delivering fast growth in an untapped $7 trillion market. I think that is an exceptional opportunity ahead of us. Reason 2, and this is an interesting one that people are starting to catch on to, is there's an $8 billion asset hidden on our balance sheet. That represents almost 2x our equity market cap. We recently took the first step to start unlocking that value for shareholders. We think that's a major catalyst. And reason 3 is there are potential structural enhancements that include internalizing management and a greatly expanded float. We think both of those will open up the Safehold opportunity to a lot more investors.

Can you give us more detail? You talked about this $8 billion asset on the balance sheet. What are you talking about there specifically?

Yes. So when you think about a portfolio of ground leases, what do you earn as an investor; you get a cash flow stream, an extremely high-quality cash flow stream, that typically has contractual bumps over time of about 2%, plus it's inflation-protected. You get CPI lookbacks. And we measure that cash flow stream against other long-dated, high-quality cash flow streams available in the fixed income world. And we think we're generating significantly above-market returns. So when you think about a bond, all you get back at the end is the same amount of dollars you put in at the beginning. In a ground lease, at the end, you not only get back what you put in but everything that sits on top of our land reverts to us. So what is the value sitting on top of our land today? Well, it's grown from about $400 million at IPO in 2017 to $8 billion today. That's a number CBRE goes out and assesses on a regular basis for us. So we have this asset sitting on our balance sheet that has grown from $400 million to $8 billion that we know we will be the future owner of, that we know has grown at double-digit, very high rates and will probably continue to do so as far as the eye can see. And yet most of the market have said, "I don't have to pay attention to this." Well, we think it's one of the most valuable components inside of Safehold. And as an investor, I look at that and I go, last quarter it was $6.7 billion. This quarter it's $8.1 billion. We've added $1.4 billion of value to shareholders. And I think this is a story you're going to see play out in 2022 much more broadly of, wait a second, this hidden asset that we've tracked since we were at IPO but we had lots of other parts of the customer code we had to crack first before we could really talk about this. But now that we've demonstrated growth, now that we've demonstrated repeat business, now that we have investment-grade ratings from the agencies, I think people can start taking a forward-looking view and say, wait a second, anything that's $8 billion that grows 2x or 3x faster than other real estate portfolios is very valuable. And that's where we are today. We've taken the first step by inviting 6 investors in on a private basis at a relatively discounted price: a sovereign wealth fund, 2 ultra-high net worth families and 3 leading venture capital firms in the country, because all of them see that exponential potential. And the fact that we've already grown from $400 million to $8 billion, this hidden asset is starting to catch a lot of attention.

I guess just help us keep going down that path of unlocking that asset. You've got CARET set up now, but what does that mean?

So yes, let's take the portfolio of $5 billion of ground leases we own. They're spitting out GAAP earnings every quarter, which is a reflection of the cash flow streams. And then at the end, we will own whatever's sitting on top of our land. We've been tracking that value. So you can think of it as a real estate portfolio basically held in our account, held in trust for our shareholders that grows both from the underlying asset values growing, and every time we do a new ground lease we get another building ownership position put in. And we send CBRE out 4 times a year to evaluate what is that package sitting on our land worth today. So give us some mark-to-market value. Don't guess what it's going to be worth at the end of a lease. Just give us mark-to-market today. And right now, that's $8.1 billion at the end of last year. We've preannounced a very strong first quarter starting to build, so that number will go up very, very handsomely in the first quarter. And we went out last year, at the end of last year, when that number was $6.7 billion to a handful investors and said, we're going to sell you 1% of this portfolio. And we were oversubscribed in about 2 weeks, and we sold a little bit more than 1% to these high net worth, sovereign wealth funds and venture capital firms at a value of $1.75 billion. So when the mark-to-market was $6.7 billion we sold a 1.37% interest at $1.75 billion value. That $6.7 billion has now grown very nicely since then. And frankly, we would not give that good a deal to anybody else, but this was the first private ground for CARET. Our commitment to those investors is we will list CARET within the next 2 years, and we will continue to grow it so that it is worth more than where they invested. And if we don't get it listed at a good price, they can unwind the deal with us. The truth is, by then, I think they will see the power of CARET, see the exponential potential. I can't imagine anybody wanting their money back in 2 years even if we haven't gone public. But we're very confident we're going to list this within that 2-year time frame.

So as you've sat through a couple days of meetings here with REIT investors, what's been sort of the feedback you've received on the concept?

I would say it's twofold and somewhat surprising to us. On one hand, I think there are a lot of people who're very excited by it. They see the footprints. We've been talking about this now for a little over a year, our plans of how to unlock this enormous hidden asset. And so they were very pleased to see the first step, the quality, the curation of the investor base. And they can kind of see that within a 2-year time frame we are committed to making this asset become a major part of the underlying value of Safehold. The flip side, and very strange to us, a lot of people were concerned that we sold the first 1% too cheaply. But wait a second, you guys have been telling us this is a $6 billion, $7 billion, $8 billion asset, how come you would sell it at just under $2 billion? We said, first of all, it was 1%. Two, we got the perfect curation of investors, the old world of sovereigns, the ultra-high net worth families who we know will love this. Rapid growth, tax-efficient wealth creation is what drives the portfolios of those kind of investors. We think CARET does that better than almost anything I've seen in my career. We also got the forward-looking investors who see this exponential scaling as a window to an entirely bigger opportunity in the proptech, fintech world that, frankly, we don't traffic and we can't see. So we can continue to market to the world we know very well, and now we have some investors who will market to the world they know very well. And they see the uniqueness of what CARET is and its potential, and they've gotten excited. So I think that combination is really powerful, but some people looked at that first trade and said, well, it wasn't giving you any value at all, but now I think you sold it too cheap. And that was very strange to us.

You hear that all the time in the REIT space. Don't feel offended by this. That's a common reaction. So I guess then just thinking about Safehold and thinking about CARET, are they the same entity? Are they different entities? Are there competing priorities in the 2? Are there complementary priorities in the 2? You've gone from a concept that people had trouble getting past anyway and now it feels like -- I'm going to say you're complicating it. You're going to say you're not. But I'm going to say your complicating it. And so how do you get people there?

Great question and a fair question. Our view is owning 100% of nothing is a lot less valuable than owning 80% of something worth $10 billion. So our goal is to figure out how to unlock this value, of which Safehold will always own the majority, in our minds. So think about ground lease portfolio; Safehold owns 100% of the cash flow streams from that portfolio and its cost basis, and it owns about 84% of all the upside above its cost basis, i.e., CARET. Management had an agreement where it could earn into 15% of CARET if the stock hit certain price targets. It has done that. So right now, CARET owns -- or Safehold owns about 84%, the new investors own 1.37%, and management has just a touch under 15%. That dynamic of Safehold being the arbiter of how to build the ground lease ecosystem will always stay in place, in our minds. Safehold makes the decisions. It owns so much of both, it will always make good decisions. It will never make decisions that harm in any material way one side or the other. So the governance question that I think is a complication, we're going to make as simple as possible. Safehold makes the decisions.

I guess, to date and then going forward, how much of Safehold's decisions have been about the actual ground lease versus this, call it, phantom value, sorry, for using that term, but the phantom value of the assets sitting above the ground?

No, you're not allowed to say phantom value. It's not acceptable. It's a tangible value. So all of Safehold's decisions as the directors are about maximizing the value to Safehold shareholders. So that's their mission. If we can extract value in either pocket that increases the value of Safehold shares, that's their mission. We haven't had that issue because, candidly, most of the market is not giving credit yet to CARET, but as CARET becomes more valuable, Safehold will be able to try to lift the value using all the tools at its disposal. It will be the largest owner of CARET and it will have the most visibility into the cash flow streams. I don't really anticipate a lot of conflict, to be honest. I think we've set this up in as simple way as we can. And true, there are -- it introduces some new complications that people will have to work through. But we work through them relatively quickly, in our minds, with our advisers and we see a relatively straightforward path to unlocking value for all shareholders.

I guess maybe the question is a little bit naive, and forgive me if it is. But is there a situation where you may do a deal that's less impactful on the value or the cash flow of the actual ground lease, but you see more value in this permanent asset on it? And so it would have been ex CARET because you're going from 0 to something. You would have said, okay, well, we don't have to focus as much on the 0 to something because something is better than nothing. But we're going to get these really good cash flows. And now you're saying, I'm getting value for this something. So as long as my something is big enough, the value of that cash flow doesn't need to be as big. Or is that an overly naive question?

Well, here's -- let's fast forward to CARET is trading and Safehold owns 80% of it. And its interest is worth $8 billion and its cash flow stream is worth $8 billion, too. And so it has a choice now, deal comes in, and it can do exactly what you're saying. It can do this and go, how do I create the most value? If it does something stupid and destroys the value of CARET, it's $8 billion asset could go to 0. So I don't think it's going to do anything that damage the value of that. If it does something stupid and makes the cash flow value drop $8 billion, all it's done is killed its golden geese. So our view is economic alignment is always the purest form of fairness. They will look and go, if I can make more money doing a deal slightly this way or slightly this way, I will do that. But most of the time you're just going to go maximize the value of the deal because you own $8 billion of each. You can't afford to have the market go, wait a second. They're ripping off one side of their arm to put it in the other pocket. So cutting off your nose to spite your face, I don't think Boards ever do. And in this case, we think the natural order of things is so much value can be created through continuing to grow this business that there is no incentive to ever try to do something that isn't making the business better, stronger, more valuable. And so we don't have to set up a lot of very complicated rules. There's one basic rule: maximize the value to Safehold. Not to CARET, not to cash flow, to Safehold.

I've got a question here in the live QA queue just asking you to talk more about the recent equity raise that you did and how you thought about valuation in that context.

Yes. So look, I wear a lot of scars from being short liquidity in a crisis in my past. So we did not want to be short liquidity given what was going on in the world. We raised our unsecured revolver from $1 billion to $1.35 billion. We did a 30-year unsecured offering, the first one for $475 million, to pay down that revolver, and we've done the equity offering to bolster even further our liquidity. So we feel like we're in a really strong balance sheet position no matter kind of what happens. We also have record growth going on in our company. Customer adoption rates are going up very dramatically. So all those things suggest that equity offering made sense to us. We hated the price. Again, we kind of think between the cash flow streams, mark-to-market and the value of this hidden asset, $150, $175 value is more, in our minds, what share value is. But the market is what it is, and we did not want to go through this period of uncertainty being worried about our ability to serve our customers when they need us. So overall, if you have a long-term view of where this business is, every deal we do is highly accretive, probably more accretive than any business we've seen. We're creating cash flows that are well above market and inflation-protected. We're creating this ownership pool that is unique and valuable. So stopping the machines seemed a poor choice. Continuing to serve our customers, we think, will create the greatest long-term value. But we certainly -- now that we can actually speak because we've been blacked out for so long, we couldn't really tell our story, we'd certainly like the stock to reflect what we think is not only the intrinsic value today but the growth prospects going forward.

If we can go to the beginning of the conversation, you talked about changing ground leases for the better. Give us more details on what you've actually accomplished and what more there is to do there.

Yes. So when we first came up with this idea of the modern ground lease, the fundamental change was going from a landlord-focused structure to a customer-focused structure. And a customer is the building owner, the building developer, the building buyer, providing them a better capital solution than the traditional financing markets which try to finance the land and the building together, both of them sort of not quite perfect efficiency, but who cares. Well, in today's market, that inefficiency can't exist. The capital markets want efficiency, investors want efficiency. So by providing a capital solution that could increase equity returns by 300 to 500 basis points on a 10-year pro forma could lower the amount of transaction costs when an asset is financed or sold or transferred over its life. By reducing the maturity risk by lowering the amount of debt on that building, we think we substantially enhanced the way you can capitalize a lot of the real estate in this country. Now we only focus on the top 30 MSAs. We've gone back in history and looked what happens in markets. And in the top 30 MSAs where you have cultural centers, financial centers, educational centers, technological centers, values of land and what's on top of the land are constantly being increased by the real estate entrepreneur community who not only thinks about location, location, location, but what is the highest and best use of that location. That's the dynamic that Safehold captures in a unique way, in a way that no investor has really had a chance to participate in historically and certainly has never been a growth industry. So we think we've changed the game by changing the relationship to our customers from antagonistic to value-creating. We did that by simplifying, standardizing and eliminating all the provisions in a historic ground lease that we as lenders, we as net lease players, right, we can't underwrite fair market value resets, reappraisal mechanisms, provisions that are completely ambiguous about what approvals are necessary or not to enhance a building's value. It kind of took a team of very smart legal scholars and said, let's create a standardized, best-in-class, customer-facing, customer-friendly ground lease. Let's figure out how to access the lowest-cost capital in the marketplace and let's deliver that to our customers because those efficiencies, they make the pie bigger and we'll give an extra slice to our customer and we'll take an extra slice. And now what have we done? We've taken a win-lose relationship and we've turned it into a win-win relationship. So that's our theory, let's go do this. Every broker, every real estate owner, developer, every lawyer said, ground leases are terrible. Ground leases are awful. We're not going to do a ground lease. It took us 1.5 years to start changing that mentality, to see that we were very serious that we were going to modernize this business, that we were going to provide better capital that would actually allow them to earn higher returns with less risk. Cool. We've done that. And we waited to see does that customer come back. Have we really cracked the customer code? They could do 1 deal because we're very persuasive. Will they come back and do the second? And we have a very simple metric, which is, are we making calls, are we taking calls? As long as we're making calls, we're selling the product. As soon as you're taking calls, the product sells itself. We're -- about 2 years ago, we started taking calls, and now we're very much in take-call process. So I think we've -- to your question, I think we've crossed the first major hurdle, which we've got a large part of the commercial real estate world, at least considering the modern ground lease as a potential tool for them that could be beneficial. We haven't reached everybody. Certainly, I would tell you, we feel like we're in the first or second inning of this opportunity. A lot of skeptics still exists who have bad historical experiences with landlords who frankly didn't care about the building owner as a customer. But slowly, but surely, I think, Manny, we're seeing more and more product types. We're in life science; we're in student housing. Multifamily is our fastest-growing product type. We're in office; we're in hospitality; we've been able to do some industrial. It tells us we're on the right path. It tells us our growth curve still feels very, very exciting. And now as people are starting to see the customer piece come into focus, now we get to go to work on the valuation piece. And I can only tell you as somebody who's looked at this industry for 30 years, this is one of the best opportunities to create wealth and above-market returns we've ever seen.

Are others doing this, Jay, following your successes?

So we've seen some new entrants in the last 12 months. I would say our goal is to be the Walmart of the industry. We want to own the low-cost positioning, which we think represents sort of the 80% fairway of our go-forward business as we see it developing. There will be others who take the edges who can do things slightly different. If you want a higher leverage ground lease, we think that's a bad idea. We don't think that makes economic sense, but others are offering that product. If you want to do some buyout structures, which we think eliminates your ability to be the low-cost provider, that's a smaller piece of the puzzle. The big main thing here is provide a better, lower-cost solution to our customers. So we are laser-focused on winning the middle of the fairway, which we think represents, again, of the $7 trillion opportunity the vast majority of it.

How much do we need to think about rates and inflation here for your business?

So we compete against the traditional finance markets. As they get impacted by rates, we move in tandem with them. I think the one piece maybe the market has missed in this current environment is we do have embedded in our cash flow stream something called a CPI lookback, that every 10 years on average, and this is not in every single deal but it's in most of our new deals, we get the lookback. And if inflation has run above the 2% contractual bumps, we get to start the rent in year 11 as if we were bumping our rents at inflation. So we think it picks up about 80% of the increase. If there's a 100 basis point increase in inflation, our ROAs go up about 80 basis points on our standard form structure. We do cap that number at 3% to 3.25%. So if inflation is going to run at 7% for the next 90 years, we don't have protection. If you think inflation is going to settle out in that 3% range over long periods of time, we're really nicely protected. So it's strange right now. I think people are increasing the discount rates on our cash flow because of inflation, but they're not adding it to our ROAs because those first resets don't start for another 5, 6 years. But really, when you think about the ROA of a bond, you should be taking all cash flows. And we think, then when you run it, you see we pick up about 80 basis points of that 100 basis point increase in inflation.

In the few minutes we have left here, can you talk about the relationship between SAFE and STAR?

Yes. So it's -- I'd like to think of it as how do you get from 0 to climb the first $5 billion mountain? We needed a lot of support from iStar. We needed their network; we needed their relationships; we needed their experience; and we needed their capital, frankly. We can't afford the same infrastructure starting Safehold that we could at iStar. But we wanted 14% of that talent, 14% of our construction team, 14% of our legal team, 14% of different parts of the firm. And it allows us to scale Safehold much faster. What we said to the market is that when we get to that first hill, that $5 billion hill, we should relook at this. Because when Safehold reaches scale, maybe we can afford 100% of that person. And maybe there's a better structure than external management because a number of investors have said, love your business; think it's going to be incredible. But external management just doesn't make sense. Rating agencies have said it; fixed-income investors have said it. So it's definitely something STAR and SAFE recognized could be holding back Safehold's share price. And think about this, because STAR owns 65% of Safehold, it has exactly the same motivation. Whatever unlocks value for SAFE is a good day for STAR. Whatever hurts value at SAFE hurts STAR shareholders. So we think if they can get in a room and actually talk about, are there better ways to do this that will unlock value and the shares go up, there may be a very interesting meeting of the minds. Nothing has happened to date, but we are getting into that $5 billion zone. And so I would imagine the potential during 2022 for them to have that conversation.

Maybe a little bit less relevant for the way you run your business, but we've been asking everyone what your #1 ESG priority is in 2022?

We've got an interesting idea that isn't fully formed. We call it Safe Planet. And essentially, what we're trying to figure out is if we can help our customers future-proof, make their buildings more sustainable, that's actually good for us, too, from a credit perspective, from a customer perspective. So Safe Planet would offer incremental proceeds on a ground lease if they're deployed into a building to make it more energy-efficient, more economically -- environmentally friendly, triple-pane glass instead of double-pane or single-pane glass. So we think there's some interesting ways to use Safe Planet to help them to help us. And so we haven't rolled it out yet. We're still working on some of the nuances, but we're excited about the potential to use our long-term commitments in the ESG space on behalf of our customers.

Right. With that, I think we'll wrap it up with a rapid-fire questions. What will the 10-year treasury yield be a year from today?

I think markets are efficient. So whatever it is right now.

I'm going to ask this question twice. Will the net lease sector have more or fewer public companies a year from now?

Net lease should definitely consolidate, so I would say less.

And what about the ground lease sector?

Ground leases, there will be a few more players, but who will find it increasingly hard to enter the business in a scalable way.

Great. Thank you very much.

Thanks, Manny.