2023-12-12 06:51:20 ET
Summary
- Safehold has seen strong performance, outperforming the broader REIT market with a 24.8% total return.
- Q3 2023 results showed stable operating results and minor investment activity, indicating an unchanged situation in the market.
- Over the quarter, Safehold achieved an upper investment-grade credit rating from Moody's and made notable steps in deleveraging its balance sheet.
- Despite the recent run-up in the share price, SAFE is still ~68% below its peak when the Fed started to increase rates.
- Once the Company has improved its capital structure even further and the interest rates seem to assume a declining trajectory, SAFE has become an even more attractive investment.
Right before Safehold ( SAFE ) issued its Q3 2023 earnings , I published an article on SAFE indicating a huge upside in case the interest rates would start to finally converge back to more accommodative levels.
Because of its underlying cash flow nature, where the contracts with property developers are typically stipulated over 90-year period and include only minor bumps or indexation to core CPI, there is a huge exposure toward duration risk.
Plus, the fact that SAFE applies very prudent underwriting tactics, the cash flows are further aligned to common plain vanilla fixed income securities. In fact, if we speak about only the duration, I would certainly argue that the duration factor is more pronounced within SAFE's structure than in any typical U.S. Government bond (even compared to jumbo bonds).
The chart above is a clear proof, where we can see how SAFE has responded to the change in Fed's stance since early 2022. No other safe or investment grade bond has plunged so deeply as SAFE. Plus, we have to also factor in that in SAFE's case during this time there have been no major headwinds that would be associated with company-specific struggles, which is only logical given investment grade credit rating and very simple business model (i.e., leasing out land for a long period of time).
Now, since the publication of my article, SAFE has done very well.
On a total return basis, SAFE has registered 24.8% gains and outperformed the broader REIT market by a huge margin.
Let's take a look at the key drivers behind these results and try to understand where SAFE could be heading forward.
Thesis
The Q3 2023 results came in with no major surprises, but with several positive signals, which were greatly welcomed by the market.
During Q3, SAFE originated a new ground lease at $19 million, which was funded purely from SAFE's internal cash positions. The relevant credit metrics here were in line with the existing (solid) portfolio quality - i.e., GLTV of 43%, rent coverage of 3.2x and an economic yield of 7.1%. Plus, during the quarter, there were ca. additional $60 million of ground leases, which were funded but that were already announced as a part of Q2 2023 package. The overall credit and yield KPIs were also in line with the portfolio average.
So, the investment activity in Q3 was very minor, which is indicative of an unchanged situation, where buyers still cannot fully agree with sellers on the right cap rates given the uncertain interest rate backdrop.
Consequently, the operating results were rather stable. If we backed out of the impairment of goodwill and excluded costs associated with Caret package (all of which are mostly non-cash items), the net income would land at ~ $22.5 million or EPS of $0.33. Again, this stability should not be a surprise since SAFE has effectively isolated all of its near-term debt maturities from interest rate volatility and the top-line stems from very stable contracts.
Now let's focus on two interesting items, that should improve SAFE long-term prospects.
First, in Q3 2023, SAFE managed to obtain an upper investment grade credit rating from Moody's, going up a notch from BBB+ to A3. This is a significant milestone for SAFE and its debt financing costs, which play a major role in how the Company creates value. According to the management , SAFE has already managed to benefit from cheaper financing costs at ca. 12.5 basis point level in the revolver. With that being said, not both credit rating agencies have assigned an equal rating. Namely, Fitch still holds BBB+ with a positive outlook.
Considering that there is a strong correlation and consistencies among all three top-tier credit agencies and the fact that Fitch has already indicated a positive outlook, it should be just a matter of time until SAFE captures an upper investment grade rating from the second agency as well. Once this is done, cost of debt should decrease even more.
Second, in early August, SAFE issued $152 million of new equity $21.40 per share, where $1.4 million was bought also by insiders. As a result of this transaction, SAFE made rather notable steps in deleveraging the balance sheet by retiring part of the relatively high cost revolver.
Q3 '23 Safehold Earnings Presentation
Because of the fresh equity proceeds, the remaining ~$1 billion of credit revolver is mostly fixed through financial and economic hedged several years in the future.
This in conjunction with 22.4 years of weighted average remaining debt maturity profile places SAFE in a very stable position from which to continue collecting its long-term cash flows.
In a nutshell, from Q3 2023 data we can safely conclude that SAFE has managed to de-risk its position even further by decreasing the exposure towards the unhedged part of the revolver and obtaining access to cheaper debt financing.
Granted, the extra dilution was a bit painful given how low the current share price is, but for the long-term game, this definitely could be deemed as a justified move, providing an additional layer of safety in case the interest rates continue to remain elevated.
Finally, if we look back at the chart above, it is clear that the aforementioned results were not that stellar to fully explain the recent price surge, which has taken place despite the equity dilution effect.
In my opinion, the key catalyst for such a reaction was the increasing consensus among the market participants of gradually normalizing interest rates in 2024. This has relatively recently sent many equity and especially fixed income markets materially higher.
In SAFE's case, the movement has been extremely strong as the Company embodies a heavy duration factor.
The bottom line
After Q3 2023 results, SAFE's capital structure has become more robust and the future financing prospects have improved due to higher credit rating and partially paid off credit revolver, which now positions SAFE with no debt maturities and exposure to variable rate financing at least until 2026.
Despite the recent increase in share price, SAFE still trades more than 68% below its peak when the interest rates were kept at accommodative levels.
There is a huge upside embedded in SAFE for investors, who believe that the interest rates will go down before 2026, which at this particular moment seems fully possible, especially when the overall consensus prices in a first cut already in 2024.
For further details see:
Safehold: Greatly Positioned For An Outperformance (Rating Upgrade)