Summary
- Safehold reported Q3-2022 results and came in ahead of expectations.
- The gain on sale was primarily responsible for that.
- The REIT ramped up its unsecured credit line usage and interest expense jumped up significantly.
- We tell you why the bonds might be the better bet here.
Note: iStar ( STAR ) is due to merge with Safehold ( SAFE ). Whatever is said about SAFE, applies more or less to STAR as well.
When we last covered SAFE, we suggested that earnings would likely contract in 2023, driven by macro headwinds. We assigned a low fair value to the company.
Sure, there may be some that will hang on to the minutest amount of Caret Units being sold to a third party. We don't ascribe any realistic value to those. We are now looking for a price based on 10X EPS numbers for 2023 or about $16-$17. Stay out, you have 50% more to go.
Source: Earnings Contraction In 2023 Should Be The Final Nail
Despite the eighty-sixth consecutive complaint from the bulls that we did not understand the company, the direction proved to be right, again.
Seeking Alpha
Staying out of SAFE and STAR for the last year was a great decision and the REIT continues to struggle to make up ground versus the broader indices.
We look at Q3-2022 earnings and give you our take on how we see this playing out for the year ahead.
Q3-2022
The reported earnings per share were a "beat", thanks to the gain on sale , which came very late in September. Analysts generally don't factor these numbers in.
Safehold Q3-2022 Presentation
SAFE did provide numbers excluding these and we saw a solid year-over-year figure.
Safehold Q3-2022 Presentation
What we have to keep in mind is that SAFE is also excluding merger related expenses from this earnings number and that is quite a significant amount. We are referring to the "other expense" of $6 million.
Safehold Q3-2022 Presentation
Excluding the gain on sale, income was about $17.3 million. That compares to about $20.4 million in Q2-2022.
Safehold Q2-2022 Presentation
The Surprise
The capital market activity was a surprise to us. SAFE did originate more than what we expected.
Safehold Q3-2022 Presentation
The positive was that this was all in the multifamily asset class. We view this as a far superior choice than the single tenant office category. The negative was that SAFE directly ramped up its credit line usage. Last quarter the unsecured line was at $445 million.
Safehold Q2-2022 10-Q
At the end of Q3-2022, this was ramped to $630 million.
Safehold Q3-2022 10-Q
This is a floating rate line and interest rate hikes will flow directly to the bottom line.
Safehold Q3-2022 10-Q
We are already seeing some impact from the earlier Fed hikes. In Q3-2022, interest expense was $35.46 million.
Safehold Q3-2022 Presentation
Compare how much revenues and interest expense moved in Q3-2022 (above) vs Q2-2022 (below).
Safehold Q2-2022 Presentation
Yes, revenues did expand faster than interest expense, but barely. Next quarter will be an interesting one to observe on this front as Q3 and Q4 rate hikes flow through that $630 million.
Cash Flow
For us, cash flow is always to be evaluated by removing out changes in working capital and also by removing out non-cash management fees from the equation. On the former, we believe that over time changes are canceled out. On the latter, we believe that it is important to count true owner's earnings and that in our opinion requires counting what management keeps. This is particularly true in REITs where share counts always move up via equity raises. We will note here that non-cash management expense was more than 41% higher versus 2021. Dane Bowler has done a great job illustrating how much more this compensation will be increasing after the merger. Hence, you don't want to lose track of this number.
Safehold Q3-2022 10-Q
Subtracting out those three numbers from cash provided by operating activities, gets us to (checks math twice), $10.5 million. That is over nine months (not just this quarter) but put that in context of SAFE's enterprise value.
Also, put that in context of the dividend payments.
Safehold Q3-2022 10-Q
Even if you don't subtract the non-cash management expense, the dividends are not covered by cash flow.
Outlook
SAFE is a heavy bond proxy. That is something we told you a long time back. You can see the movement in the 10-year Treasury rate and SAFE's dividend yield matching each other quite nicely.
If the terminal Fed fund's rate reaches 5% and the 10-year Treasury rate follows, there will likely be substantial pain ahead for SAFE. From a fundamental perspective this makes sense as well. SAFE's floating rate interest expense on $630 million of debt will move up significantly. We will remind readers that this is a cash expense. SAFE has a lot of non-cash revenue and a good deal of non-cash interest expense. But from a cash flow perspective this will really bite as this additional interest expense is all cash.
Verdict
We were quite surprised as SAFE dialed up the credit facility usage. Perhaps this is an explicit bet on interest rates reversing soon. We think that is unlikely to be the case. At this point, while we see the equity as still risky and maintain our $17 price target, we think the bonds are looking interesting from an asset perspective.
FINRA
A 6.766% yield to maturity is quite decent when you consider the safety of ground leases. Rent payments are unlikely to be cut even in the most extreme cases and we believe the assets are enough to at least meet the debt obligations. Consensus NAV is $46, but we think it will be a stretch to get that much in this interest rate environment, $20-$25 is more likely. Nonetheless, the debt is above the equity and there is a good buffer here. The 2031 maturing bonds were offered at a time when the 10-year yield was 1.63% and offered just 1.17% spread over the risk-free rate.
Today, we are getting a solid 260 basis points and of course, the 10-year Treasury rate is far higher. We think these offer investors a good way to play SAFE with far lower risk than the common equity.
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: Bonds Might Be A Better Alternative