LANDM - Safehold: An All-In Bet On Lower Rates

2023-08-03 12:10:22 ET

Summary

• Safehold reported results in line with expectations.
• Earnings contracted once again versus last year.
• The company added more to its floating rate debt.
• New Investments generated an attractive rate of return.

Early in 2023, we had the opinion that Safehold ( SAFE ) was poised to continue along the same trends of 2022.

That stance was based on three facts.

1) The mega-bubble of SAFE was till imploding.

2) "Higher for longer" on the interest rate front was still not priced in.

3) Earnings were likely to contract.

That thesis has worked so far with SAFE down 26.66% since that article was released versus Vanguard Real Estate ETF's ( VNQ ) negative 3.09% .

We also threw in Farmland Partners Inc. ( FPI ) and Gladstone Land Corp ( LAND ) in there. While neither of them are ground lease REITs, they share two characteristics with SAFE. The first being that if you have been seduced by the "buy land, they are not building it any more" line, well FPI and LAND are your other "go-to" REITs. Both are also exposed to land prices and own very low cap rate properties, financed now with a rising cost of debt. Our point was to show that even in that group, SAFE is struggling on a relative basis.

Q2-2023

To get to the reason SAFE is not doing too well relative to REITs with similar issues, one has to just look at the financials for Q2-2023. SAFE reported about in line with all expectations, but that still meant that earnings contracted, despite a 32% increase in revenues.

Notable here was the fact that interest expense expanded at a 52% rate year over year for Q2-2023. Stock based compensation was up almost 7x. Those are big numbers. Year to date, earnings are down to $0.42 versus $0.78 last year. SAFE does have an adjusted earnings number, which excludes all merger related expenses. Even that is down year over year.

Stocks always move in relation to expectations. SAFE did meet analyst estimates for this quarter, but the story is what happened to the crowd that bought the growth mantra in 2021. That story stock was supposed to deliver earnings of $2.11 in 2023, $2.31 in 2024, $2.50 in 2025 and $2.94 in 2026.

No one apparently bothered to check what would happen when interest rates rise.

2026 estimates are now lower than where 2023 estimates were 18 months back . In the interim, SAFE has gone all-in on the floating rate debt with unsecured revolver now at $1.048 billion. This was at $690 million at the end of 2022.

Last quarter we were at $970 million and in March 2022, SAFE had only $235 million on this .

So as bad as the interest rate expense was this quarter, we are about to see new highs in both Q3-2023 and Q4-2023. On the cash flow side, things look bleak as well. Operating cash flow over the last six months was negative $9.47 million.

As we have always done, we exclude the impact of changes in working capital. So if we remove the impact of those changes, operating cash flow was about $0.5 million for the first six months. To reach that $0.5 million of operating cash flow you have to add back $17.8 million of non-cash stock based compensation and management fees.

Perhaps we skipped a few accounting lectures and maybe that is why all of this "Safehold is cheap" arguments are not making sense. But when you get a company with a $5.3 billion enterprise value producing $0.5 million of operating cash flow over six months after adding back $17.8 million in management expenses, it does seem a little expensive still.

Maybe we are missing something.

Verdict

There was some good news for investors as cap rates exploded everywhere alongside risk-free rates. New investments have actually started to look quite attractive for SAFE and SAFE's increased usage of the unsecured revolver came with a better return profile. 7% weighted average cap rates for land leases are pretty good and that is what SAFE got in the most recent transactions.

During the quarter, we originated three new ground leases, totaling $129 million. We funded $73 million during the quarter with $61 million of that associated with new and existing ground lease commitments and $12 million related to our 53% share of the leasehold loan fund, which we acquired in the merger.

The three new originations were all multifamily properties with three new customers across three unique markets. Of the $129 million, $39 million consisted of two transactions closed into our aforementioned venture, and the third deal for $90 million will be wholly-owned by Safehold. These leases generate a 7.2% weighted average inflation adjusted yield or a 7.1% yield, assuming 0% inflation and no Caret value.

Source: SAFE Q2-2023 Transcript

The flip side of that is if you apply those kind of cap rates to SAFE's NAV you will land with a value in the low teens.

SAFE is a bet on low interest rates and one where returns are still likely to be extremely poor from this point. Current interest rates that SAFE is paying on its fixed rate debt are very low and if you move them up by even 1-2% over time, you will neutralize a lot of increased cash flow.

1-2% is hardly a stretch here as even SAFE's 8-year out bonds have a yield to maturity that is almost 4% higher than the rate they were issued at.

Those enamored with ground leases (we aren't), can consider these. In fact, we think that the SAFE bonds will still beat SAFE common shares over the next eight years, despite SAFE shares being down 70% from the highs. We have previously recommended these, but at present we are finding a lot of 7% plus yields in corporate land that we think are better bets. So these remain on our watch list.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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