Summary
- Safehold's mega bubble pop is still deflating.
- Higher for longer is the new interest rate mantra from the Federal Reserve.
- Operating Earnings contraction is written in stone for this year and earnings estimates are still too optimistic.
- We will likely make a bottom this year though and we tell you how to play that.
Author's Note: There is a pending merger between the two companies discussed. We expect them to move in a similar manner until then.
Safehold Inc. ( SAFE ) and its parent iStar Inc. ( STAR ) have been a trader's dream. The stocks had some great exciting moves in late 2021 and 2022.
Of course that looks like a straight downward move when we zoom out but there were a lot of exciting countertrend rallies to suck more investors in. For example, if you bought at June 2022 end and sold into the merger announcement, you made a cool 31% in SAFE.
With Q4-2022 results out and the merger likely a few weeks away, we see what 2023 holds for holders of these stocks.
Our Thesis
Bubbles suck you into thinking "this time is different". Regardless of how obvious it may be, analysts get pulled into the "new paradigm". SAFE was no different. At the peak the stock traded at one of the most absurd valuations we had ever seen. We highlighted the absurdity of these guaranteed loss making entries in an article about 17 months back.
SAFE has underperformed the S&P 500 by a little bit since then. What we had quoted then holds a lot of value today for anyone that still believes that bubbles can defy the law of gravity.
The first base case here is that SAFE will trade at 20X at some point and that comes to $36-$45 depending on when exactly that happens. Another way we would see this is that we think that SAFE will yield at least as much as the medical office healthcare REITs. We view those as safer and higher quality than SAFE, so at the minimum, the two sets should have similar dividend yields. For SAFE to yield 4% its price would have to be about $37.50 (assuming it eventually pays $1.50 in dividends). Finally, we see SAFE requiring at least 2% over the 10 year Treasury rate (which we see as going to 2.5%). That would get us to $33.33, again assuming that SAFE lands up paying $1.50 eventually. All of these will create zero total return pathways over the next 7 to 10 years.
Source: Long Way Down To Normal Valuations
The math here was pretty simple and quite logical to assume. The lowest of these 3 price points ($33.33) has actually been comfortably breached and the stock sits below that today.
But unfortunately for SAFE, the fundamentals have turned out far worse than what we assumed. The 10 Year Treasury for example, is now at 3.86%. We had also assumed this valuation compression would take very long, allowing SAFE to gradually raise the dividend to meet our minimum valuation requirements. The result of such a rapid drop has meant that SAFE has not got the time to raise its dividend. If we applied the original criteria to our model, it would mean that SAFE would have to yield 5.86% today. That would mean a $12.00 stock price. Even if you don't buy that possibility, keep in mind that SAFE's dividend yield is tracking the 10 year Treasury rate with a very high correlation.
With the 10 year yield breaking out of a long consolidation pattern, we see more volatility in store for SAFE.
Not Just The Long End
In the most recently reported quarter SAFE missed GAAP EPS estimates by 4 cents . That is quite a delta (10%) on a quarterly number. We believe there were two major factors which put analysts offside. For SAFE, the revenues are extremely predictable and usually easy to forecast. The problems came from a slightly higher general and administrative expense number, but more so from the interest expense.
Interest expense was up 69% year over year. Compare that to the revenues which were up just 41% year over year as SAFE bought multiple new ground leases. The rise was so steep that earnings contracted. Yes, that growth story you bought into at 70X earnings at the peak, is now contracting. Getting back to the interest expense, there are some notable changes in the debt structure ( 10-K link ).
While the first two highlighted categories are fixed rate, the unsecured revolver is the one that likely caused the earnings miss. SAFE has dialed up use of this over the last 6 months. See numbers from June 2022 below.
So a far higher amount on a rapidly rising variable rate portion of the capital structure is what is causing the pressure. We will add here that these rates move with a lag to the Fed Funds rate and we are nowhere near done yet in terms of how much pressure is coming. Currently the market is pricing there is a 63% chance of 3 more 25 basis points hikes by June 2023!
Jim Bianco ( who made the above chart ) has nailed the reason for this as well. Inflation expectations are surging and getting detached from Crude oil.
If we get a terminal rate of 5.5% or even 6.0%, there will be massive pressure on SAFE's cash flow and earnings. You can easily extrapolate the delta from the good old days of 0% or virtually 0% LIBOR, to 6% LIBOR.
$490 million in borrowing means that at LIBOR plus 1% you are paying about $5.0 million in interest annually. $690 million at 6% LIBOR means that you are paying $48.0 million annualized in interest.
Verdict
SAFE's 2022 and 2021 cash flow reiterates our longer term point. For 2022, SAFE had about $35 million in operating cash flow if you ignored the changes in working capital.
For 2021, this was about $38.5 million. For 2020 this was about $37.5 million. We consider this really low in relation to the $5.5 billion market capitalization.
Just investing $5.5 billion in 1 year treasuries would yield over $275 million annually. More importantly, this operating cash flow before working capital changes will constrict in 2023. JP Morgan's November 8 2022 report on SAFE estimated a free cash flow (a proxy for our metric) of $0.05 per share in 2023. That is stark contrast to GAAP earnings, which will be closer to $1.56 per share. Which of the two is more relevant? Assuming you believe it is the $1.56 per share, it is perfectly reasonable to assume SAFE trades at 10X-12X earnings at some point. We think you will need a minimum yield of 4% to start drawing in the value buyers for the long term land play which is the main appeal behind SAFE. We think 2023 will present lots of volatility with a bias towards the downside and at a minimum we will break $20.00 per share. We would look to buy in the $16-$18 range. We rate both SAFE and STAR at Hold/Neutral for now.
How To Play-Buy Bonds And Chill
If you are bullish SAFE, the bonds are an awesome way to express that. We have said this a few times now and they continue to outperform the common shares.
They also have a yield to maturity of 2.4% over the 10 year Treasury yield, something we believe is a great deal for ground lease backed cash flows.
iStar's three preferred shares have actually been our favorite.
1) iStar Inc. PFD SER G ( STAR.PG )
2) iStar Inc. PFD SER I ( STAR.PI )
3) iStar Inc. PFD SER D ( STAR.PD )
We have highlighted these as well a few times.
All three are past their call dates and likely to be retired as STAR's uses the merger to converge the cost of debt between the two companies. We see the preferred shares as an indirect NAV play that balances the overvaluation of SAFE with the relative undervaluation of STAR.
Source: Undervalued Parent, Overvalued Daughter
Since our April 2022 article, the preferred shares have outperformed SAFE by 46% and STAR by 54%. Unfortunately, we cannot tap that well for much longer as the redemption date is close and they are trading very close to par on a stripped basis. Hence we would stick the bonds for now and look for long opportunities on the common later in the year.
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.
For further details see:
Safehold And iStar: If You Liked 2022, You Will Love 2023