2023-10-11 14:59:40 ET
Summary
- Safehold is facing difficulties due to poor timing, excessive management compensation, and aggressive accounting practices.
- The company is losing cash as a significant portion of their rent is non-cash GAAP straight line rent, while interest expense has increased.
- Safehold is unable to raise rents significantly due to long-term rental contracts, leading to negative cash flow.
Safehold ( SAFE ) is in the ground lease business in which they buy the land underneath properties and lease it back to the property operators. It is a sector I like quite a bit, but poor timing, excessive management compensation and aggressive accounting practices put SAFE in a precarious position. The company is losing cash as much of their rent is non-cash GAAP straight line rent while interest expense has soared.
In previous reports we discussed the excessive management compensation and the extremely low cash ROIC at which SAFE invested its capital.
In this article we will update our longstanding short thesis for the latest numbers, particularly impactful is the change in interest rates.
The short thesis
It is not hard to see that SAFE is in trouble if one understands the impact of changes to interest rates on long dated treasuries. When interest rates rise, all bonds lose value, but the longer duration the bond, the more value is lost. The 30 year treasury falls significantly more than the 10 year treasury. This is just basic bond math.
What Safehold has done is buy up billions of dollars of ground leases with contracts as long as 99 years and they did it at trough interest rates.
So if the 30 year treasury is hurting much more than the 10 year, just imagine what is happening to 99 year leases.
That is the broad level reason that SAFE remains a good short candidate even after its stock has fallen so far.
The company specific reasons will be discussed in the following sections.
- Inability to raise rents
- Interest expense rising rapidly
- Negative cashflow
Inability to raise rents
SAFE’s rental contracts are extremely long term. They have built in escalators, but a couple percent a year is not going to cut it given the extremely low current rent and the rapidly rising interest expense.
Most REITs are feeling the impact of rising interest expense as debt rolls over. However, most REITs also have leases rolling over and because of the combination of strong fundamentals and inflation, most REITs are able to raise their rents significantly as those leases roll.
Due to the recency with which SAFE acquired and its exceedingly long lease terms, SAFE has almost no leases rolling. As such, unlike other REITs they do not have the ability to materially raise rent. Revenues are basically stagnant and that assumes tenants continue to pay.
44% of SAFE’s book value is invested in office ground leases which is a very challenged sector right now.
There is a real chance some or even many of their tenants will struggle to pay rent. This thesis does not rely on that. For now, I am going to analyze the numbers assuming all tenants pay rent as scheduled.
This stagnant revenue might have been fine in a zero interest rates forever sort of world, but interest rates have gone from nearly 0 to over 5% for most of the yield curve. So SAFE’s assets are still earning a 3.5% cash yield while treasuries pay above 5%.
That 3.5% is not my figure. It is SAFE’s number.
The higher 5.2% GAAP yield is based on straight line rents over the course of the up to 99 year leases. It just isn’t realistic to look at the average rent over a 90 year term. Maybe in about 45 years the cash rents will be 5.2% of initial purchase price, but today they are nowhere near that level.
So that is the crux of the problem. Revenues will take many decades to reset to an appropriate level while interest expense resets immediately.
Interest expense rising rapidly
Some of SAFE’s debt is properly termed out with fixed rates. Some of it is not. As of 6/30/23 SAFE had about $1.148 billion in floating rate debt.
The $1,048,000,000 on the 2021 unsecured revolver has interest equal to 3 month SOFR + 1%. The trust preferred security is at SOFR + 26 basis points plus 1.50.
Per the 10-Q, the LIBOR term was switched to SOFR +26:
“Trust Preferred Securities —The Company assumed trust preferred securities from iStar in connection with Merger. The trust preferred securities bear interest at LIBOR plus 1.50% and mature in October 2035. Effective July 1, 2023, LIBOR was replaced with a rate equal to three-month Term SOFR plus 0.26161%.”
Given the amount of floating rate debt we can calculate the immediate increase to interest expense as rates rise. Much of the increase already happened before the latest report (2Q23) but what I am particularly interested in is the change since that time.
The interest expense figure presented in the 2Q report was based on the weighted average within 2Q23. Halfway through the 2 nd quarter 3 month term SOFR was 4.98%.
Today it is 5.42%
That is a delta of 44 basis points.
With $1.1B floating rate debt the raw increase to interest expense from a 44 basis point rise in SOFR would be $4.84 million.
SAFE has some swaps in place to partially protect themselves.
Swaps are often poorly presented, which makes it difficult to tell exactly how much they help. Fortunately, SAFE also presents an interest rate sensitivity table which is inclusive of these swaps.
Inclusive of the effects of swaps the additional interest expense from the 44 basis point delta in SOFR is $2.851 million as compared to the previous quarter.
That is not all that much, but it adds on top of the already enormous interest expense that has piled up as SOFR moved in previous quarters from near 0 to where it is now. This incremental interest expense takes cash earnings deeply into negative territory.
Negative cash earnings
Here is the income statement from 2Q23:
Notice that interest expense and G&A of $46 million and ~$19 million, respectively eat up the majority of total revenues which were $85.6 million. Add on the increase of $2.851 million interest expense ($712K quarterly) from the rise in interest rates since quarter end and SAFE is sitting on quarterly interest expense of $46.767 million. With G&A, that is $65.6 million quarterly expense in just these 2 line items.
Note that a large chunk of the revenue is non-cash straight line rent from the aforementioned long leases. The statement of cashflows reveals just how much of that rent is from GAAP accrual accounting.
Note that the above image is a 6 month figure so cut the $41.084 million in half to get the quarterly run rate.
That leaves the cash revenue run rate at $85.661 million minus $20.542 million. That is $65,119 in quarterly cash revenue.
As discussed in the previous section, G&A plus interest expense is at a quarterly run rate of $65.6 million.
SAFE is cashflow negative on just those 2 expense lines alone, and they have other expenses.
The error made by Safehold
I think the company approached acquisitions with very aggressive underwriting in which they looked at the GAAP cap rate and ignored the cash cap rate.
These acquisitions were extremely low margin. From the SAFE presentation we know the average cash yield on its properties is 3.5%. Even if you exclude the damage that occurred from the rise in interest rates, SAFE had weak cashflows just from the fixed rate debt.
CFO Brett Asnas on 2Q23 call stated:
“The effective interest rate on permanent debt is 3.8%”
They did manage to do some clever stuff with reverse amortization on loans where the current cash interest expense is lower with the rest of the interest accruing toward principal.
This took the cash component of interest on fixed rate debt down to 3.3%. Technically, that is a positive cashflow spread against the 3.5% cash cap rate of acquisitions. It is just a very narrow spread and as we calculated above, the rising interest expense on the floating rate debt has taken them to negative cashflows.
How bad will it get?
At this point I do not think bankruptcy is on the table as a real risk. The company can issue tons of equity to correct the situation. They have already begun doing so with the latest issuance in August.
At current prices, SAFE has a nearly 6% dividend yield so in order to make the issuance fix the cashflow situation it would need to cut the dividend.
As REIT market prices crash hard when dividends are cut, my hunch is that the company will issue as much equity as possible before ultimately cutting the dividend.
Shares are significantly overvalued relative to earnings. The sheer magnitude of management compensation seems to be getting overlooked by the market simply because much of it is share based rather than cash.
I have no idea why the market is so forgiving of stock based comp. It is a real expense and it dilutes shareholder NAV and earnings.
Risks to short thesis
Despite the cashflow situation, SAFE has a strong credit rating, recently upgraded to A3 by Moody’s. That credit rating does not help them much in the current interest rate environment as even high credit companies find debt to be extremely expensive.
It could, however, help them if interest rates were to go back down. A sudden drop in prevailing interest rates could allow Safehold to replace the expensive variable rate debt with slightly cheaper fixed rate debt. My base case is not a sharp drop in interest rates, but that macro factor has proven to be quite hard to predict.
The value per share could also be improved materially if management compensation were to be cut dramatically. I find this unlikely given the team’s history, but perhaps some sort of third party governance organization or activist investor might come in to force the change.
In summation of the risks, activism or a sharp drop in interest rates could be good early warning signs to cover a short.
The bottom line
The market price at which SAFE trades is only justified if one gives full credit to accrued earnings that they really only get 45 years into the future. I find that highly unrealistic and see fair value much lower. Given the $1.1B of floating rate debt, this higher interest rate environment is really hurting SAFE as they are unable to reset their revenues higher.
For further details see:
Safehold Is About To Be Clobbered By Interest Rates