2023-11-07 07:00:00 ET
Summary
- Safehold is a ground lease REIT that has experienced significant growth in recent years.
- The company has faced challenges in 2023 due to financing costs and interest rate changes.
- Despite these challenges, Safehold remains financially stable with a strong credit rating and ample liquidity.
This article was coproduced with Wolf Report.
In September 2018, we initiated coverage of Safehold ( SAFE ) stock with a Buy.
At the time the company was externally managed by iSTAR and had a market capitalization of under $300 million.
I had high hopes for this "pure play" ground lease REIT that grew shares by more than 130% through 2020.
In fact, from March 2020 to March 2021 SAFE was printing money:
Yet, as shown below, 2023 was not the year for SAFE:
SAFE isn't the easiest REIT to understand and requires some in-depth reading before you know what to expect and what the company does.
It's especially complex because SAFE hasn't really been through this sort of market macro environment.
It brings uncertainty not only when it comes to analysts evaluating the company and where it "should" be trading, but also the market as a whole.
We believe that this is what we've been seeing for the past few months. The market addressing a company that it does not know how to really handle.
We added shares of SAFE recently - and now we're going to show you why that is. We're adding slowly, but we're adding with the goal of eventually seeing a decent position in this stock.
Updating on SAFE - It's still Safe, for the long term
Many of our investments are companies that you need to be willing to hold for several years in order to see the solid payout that we're expecting.
Sometimes companies also turn down, and we need to extend our holding position to get the payoff we're looking for.
adidas (ADDYY) was one such company.
Wolf Report added to his position and will soon be in the green (provided we see a good trajectory), but it's been quite a trip.
These things do not worry us.
We do not invest in companies where a downturn would "worry" us.
If a missed quarter or some trouble changes our thesis on a stock, it's not a company we should have been investing in the first place.
Sometimes though, there are exceptions.
But back to Safehold.
SAFE is a so-called "ground lease REIT".
There are very few ground-lease REITs out there, but this is Safehold's business.
SAFE is New York-based, it's externally managed (more on that later), and comes with an interesting business idea.
It's the only public ground lease company available at this time, and it focuses strictly on investment-grade ground lease companies in order to increase its safety and manage only an institutional quality-level portfolio.
This means that what SAFE does is to acquire, manage, and capitalize on qualitative ground leases.
The core of this business idea is that the tenants own their buildings, but not the land that the building is built upon.
Many retailers, including companies like Macy's ( M ), utilize land leases.
It's almost completely the same as any lease - the tenant makes monthly rent payments.
With a ground lease REIT like Safehold, the leases are net leases, which means that tenants assume responsibility for taxes, insurance, and CapEx/OpEx for the duration of the lease.
SAFE IR
Overall, the only problem we have with this geographical exposure is the lack of Sunbelt and the over-representation of West and Northeast - but the concept is still solid.
We believe the reason SAFE has underperformed can be ascribed to the same problems that we've seen for other companies in similar REIT fields here - we're talking financing costs and maturities due to interest rate changes.
This is also a key reason why the last few quarters have been below the projected/forecasted earnings level.
Safe has a somewhat unattractive increasing exposure to floating rates and a floating-rate debt load.
However, that's not the same - or even close to the same - as saying the company is going to see material difficulties or a downturn due to this.
While we can certainly critique analysts, including on SA, for being somewhat too optimistic about the stability of low interest rates and missing this delta in debt, there's no danger of bankruptcy - at least that's how we see it.
What we need to look at is an increased cost of debt, and as a result of this, overall lower income. Because whatever the company does, there are no quick fixes for something like this.
3Q23 results go some ways to explain this.
The company's main presentation focus was on the equity raise worth $152M, with 7.1M shares at $21.4/share, and around 700k shares sold to insiders and MSD.
So the company is already moving to secure some of its financing and fundamentals and improve some of its fundamentals.
And it's working. Moody's recently upgraded Safehold to A3 from Baa1. (Source: SAFE 3Q23 )
So, anyone taking a stance that SAFE is unsafe needs to defend that stance in the context of a recently-bumped credit rating, a GLTV of 42% with a rent coverage of 3.7x, and a portfolio now valued at $6.4B, or an estimated UCA of $10B. (Source: SAFE 3Q23 )
We also must consider that SAFE still has more than $800M of capital and liquidity available from several sources, and more than $450M worth of capital in a JV with a leading sovereign wealth fund.
Safehold is anything but cash strapped, and we would like to remind you of the growth we've seen since the company's IPO back in 2017.
SAFE IR
It's at this point an almost foregone conclusion to us that a company like this isn't going to be massively premiumized in a market like this.
Given what they own, the activity that the company reported was nonetheless solid, with originations worth $19M in 3Q, fully funded - a multifamily ground lease with an economic yield of over 7% and two more originations at a 7.3% economic yield with GLTV close to sub-40% incoming.
So, from an earnings perspective, SAFE's revenues were up 19%, but the company went net income negative at -268%.
Not a great track record - but excluding merger and CARET costs, this was only a slight decline - from $25.5M in net income YoY to $22.5M 3Q23, which is a decline of around 12%, translating to an EPS excluding merger/CARET-costs of 18%.
The company's share count has been diluted, moving from an SO of 63.4M to 68M.
Return metrics and profitability for the company as of this quarter still remain okay. The company illustrates to investors how it arrives at a CARET valuation and illustrative CARET yield of 7.4%.
SAFE IR
We've been through these calculations several times, and we do view them as very solid - and relevant here.
The main problem that we see, and it might not even be viewed as a problem once/if NYC recovers, is the 23% exposure to Manhattan.
That also comes at the worst rent coverage in the top 10 markets, and a bad/worst GLTV of 48% (excepting San Francisco and Denver).
Again though, anyone wanting to talk risk and survival , remember that this company is BBB+/A3-rated. It has ample cash on hand, and even with this aforementioned exposure, we do not see any near-term fundamental risks.
SAFE's operating model entails an AAA-like position in the capital structure, virtually immune from the types of risks you see in single-asset CMBS.
Even with contractual inflation captures, the company's inflation-adjusted yield is over 6% at 3% long-term inflation.
Another thing that SAFE bears also often forget, or at least underestimate (in our opinion), is the value that the CARET structure offers.
We refer you to an article on SAFE for the specifics of the CARET program. The appeal outside of ZIRP has declined, relative to what's available on the market today.
We have two problems with bears on SAFE here.
First off, many characterize SAFE as a pure play Office REIT or value it similar to Office. This is false. It's a REIT with 40%-plus office exposure, but with a recent tilt much more toward multifamily investments, over 35%.
Secondly, not seeing the long-term value of this portfolio and what it offers - which is significant.
So, in our valuation, we will make a case for why you can see a 15%-20% annualized RoR from SAFE, even with just a 4%-plus yield, which is where we are today.
SAFE Valuation - Tricky without a doubt
Evaluating what we would agree is a "specialized" sort of REIT in this environment is a very tricky venture.
Typically, we really don't trust any business that claims that in order to value it "properly," you have to do X and Y. Why?
Because, especially in this sort of environment, there are a hundred attractive investment opportunities that do not require us to take unique approaches to something as simple as a business valuation.
Take Realty Income ( O ) for instance.
Why buy SAFE when you could "buy" O for over 6% yield with over 15%-20% annualized upside?
This introduces diversification, and that's where companies like SAFE come in.
You need to understand SAFE in order to invest.
You need to understand why a debt of over 10x to EBITDA isn't as worrying for a company that has no capex obligations.
Because the assumption is that once that extremely long-maturity debt comes due in over 25-30 years, the compounding nature of its cash flows will have done wonders.
It's not a wrong assumption to have either, even if cost of capital is up and the company is obviously being re-evaluated in part due to this.
In order to see the safety, you need only look at what the company has done already to improve its metric.
Back five years ago, the payout was 90%-plus of the net.
That's now less than 35% of the net at a yield of almost 5%.
The yield now is 4.25%, but the payout in terms of the REIT's FFO is 55% - and that's based on the 2023E estimates with a 13% FFO drop.
For 2024E, this is less than 50%, in fact, it's even less than 45%.
This is where your safety comes from.
And Safehold is no longer expensive by any metric.
It's below 13x P/FFO at this time, and even to an upside of only 15-16x, which based on its unique business idea is justified in a good environment, is 31.25% per year, or 80% total RoR in less than three years.
Safehold Upside (FAST Graphs)
Are you starting to see where the upside can come from here?
It's not a stretch to say that in a positive environment or context, this company can give us triple-digit returns.
The fact that we're conservatively investing means that we're not expecting that, or at least that we expect other companies to do better - but we do believe that SAFE has a very significant upside for long-term-oriented investors.
Ownership
Insiders own around ~8% in SAFE and Michael Dell's family office, MSD Capital (the predecessor to DFO), owns another 8%. Dell is worth more than $67 billion, according to Forbes .
Thesis
- Safehold is a specialized REIT, but a very attractive possibility if you consider it for the long-term and understand the appeal of land leases. The company won't deliver massive yields, but we believe it will nonetheless deliver capital appreciation and good returns over time.
- Another argument relates to the significant insider information/ownership and CEO knowledge. This is a small, strong company - and it's here where high potential returns are entirely possible.
- Coupling all of this, we see a bit of risk and perhaps not as unerringly a strong buy as for some other qualitative REITs out there - but we definitely see an upside to the company.
- We're still at a "BUY" for Safehold, and we maintain it at a current PT of $30/share, allowing for an upside up to and including 16x P/FFO for the 2025E period.
Remember, we're all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, we harvest gains and rotate my position into other undervalued stocks, repeating No. 1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, we buy more as time allows.
4. We reinvest proceeds from dividends, savings from work, or other cash inflows as specified in no. 1.
Here are our criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative and well run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has realistic upside based on earnings growth or multiple expansion/reversion.
This means that the company fulfills almost every single one of our criteria, making it relatively clear why we view it as a "buy" here. The only reason we're not calling it cheap is the relative appeal of other investments in this environment.
Thank you for reading and commenting.
Author's Note: Full transparency:
Charles Schwab
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
Safehold: A Billionaire's Bet On Ground Leases