2023-05-02 17:26:51 ET
Summary
- On our last update on Safehold, we suggested investors skip the shares and hold the bonds.
- We review and update that trade.
- We also analyze the Q1-2023 results and tell you how they fit into the picture.
On our last update on Safehold Inc. (SAFE) we suggested that investors skip past the high-risk shares and stick to the bonds.
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.
Source: If You Liked 2022, You Will Love 2023
The mentioned bonds had a total return of about 2%. That's nothing to text home about. But they certainly proved a point to the common shares.
Seeking Alpha
We look at what the Q1-2023 quarter brought and how that shapes our view on both these securities.
Q1-2023
The headline numbers were quite weak with SAFE reporting just $0.07 a share of earnings. This was an 82% decline year over year.
Of course the bogeyman here was the merger related cost with iStar Inc. While these one-time charges can occasionally be ignored, one must note just how huge they are in relation to the quarterly earnings run-rate. Now, the key point here is that even excluding these costs, earnings declined. We "nailed this" as an inevitable outcome for SAFE back in September 2022.
How did this guaranteed growth model contract, even when you strip out all one-time costs? We had two major detractors (debt load and interest rate change) which led to the increase in interest expense. Those expenses were up 61.4% year over year, dwarfing the 29.7% in revenues.
That is quite the jump. We will note here that the interest expense increase is only partially due to an increase in debt load. A year back total debt was near $3.15 billion.
SAFE 10-Q
Today we are near $4.0 billion. But the bigger change is the debt composition. SAFE has put a stunning $970 million on its unsecured revolver. It has another $100 million floating at an even higher floating rate.
SAFE 10-Q
In March of last year (Q1-2022), this was just $235 million.
SAFE 10-Q
So the annual delta here is pretty huge. SAFE went from around 2% on $235 million (remember where LIBOR/SOFR were in Q1-2022) to now 6% on $1.07 billion. So the $4.7 million of annual interest is now over $64 million annual rate. This is massive change and one that has completely befuddled the analyst community. Seven months back, they were sleepwalking into this setup expecting $1.83 in earnings.
Seeking Alpha, Sep 2022
Now we are at $1.19.
We don't believe these one-time costs should be excused, but even if you add back that merger related number, earnings estimates are for $1.63.
Outlook
SAFE has made a big bet on going with the unsecured revolver for their big financing and this will likely crush earnings and cash flow further in 2023. Management did mention some hedges, but we think this is coming in too late and any "locks" or "caps" will be far higher than if this was done 1.5 years back.
While we put approximately $400 million of long-term hedges in place over the last few quarters to protect future financings that will term out these revolver borrowings, we faced higher interest charges from market rates in the short-term. We recently executed $500 million floating to fix swaps, takings SOFR to approximately 3%, which will mitigate some of the adverse near-term earnings effects stemming from the substantial Fed rate hikes that have occurred.
Source: SAFE Q1-2023 Transcript
Earnings are being weighed down as shown above and the cash flow is coming down even faster. This is because the move is in the cash interest expense. SAFE's GAAP revenues have a huge amount of non-cash component and this part is realized over decades. This quarter's operating cash flow, even before changes in working capital, was negative.
SAFE 10-Q
We will note that we get to this negative $6.8 million even after adding back nearly $10 million of non-cash management fees and stock based compensation . For comparison, the company paid out $22 million in dividends. Of course the bull counterargument has always been that they are interested in the building ownership at the end of 90 or 99 year leases. The good news for them is that we believe they will take ownership of some of these buildings way sooner than that 9-decade time span. The bad news is that they probably won't know what to do with them.
Verdict
SAFE is trading at 23X GAAP earnings. We won't go into funds from operations (FFO) as that is likely to be negative this year. But even if you weigh the 23X GAAP number on par with an FFO multiple, SAFE still looks expensive. We can find several quality plays today at under 15X FFO and we are not sure why anyone would run into a REIT with such a narrow spread.
SAFE Q1-2023 Presentation
Perhaps this comes down to the CARET story for some.
We did not buy into this story when SAFE was $74 and we are not interested in it now. Perhaps we are reading this wrong, but we would not be interested in single tenant office buildings (44% of Gross book value) as an asset class today, let alone the promise of it nine decades down the line. Office Properties Income Trust ( OPI ) and Orion Office REIT ( ONL ) are great examples of how that asset class is doing today.
Here is some more color of what sales are actually occurring at.
Commercial real estate observers have a close eye on the Union Bank Building at 350 California St. as a benchmark for property values in the post-pandemic era. Back in 2019, brokers valued the property at around $300 million.
In 2020, when the building went on sale, the number was pegged at around $250 million. As best and final offers are coming, however, commercial real estate brokers say the building is likely to sell at just $60 million-a drop of 80% compared with its 2019 price.
Source: SF Standard
An 80% drop would push a building below its land value in 2019.
That building is 75% vacant as Union Bank moved out. It is also a multi-tenant building, which we think is less problematic versus a single tenant building. Granted, San Francisco is an extreme example, but SAFE does have office assets in the area .
As before, we remain skeptical that there is deep value embedded in the CARET setup, but we are happy to let the data prove us wrong. The data would require at least $250-$500 million worth of CARET sale and use of that to reduce debt.
We rate SAFE as a hold/neutral and don't think investors will see upside from these levels. One related fun fact is that if we were wrong and investors did see a 10% total return from here, every single year, top pickers would break even after 2035.
Google Finance Author's Calculations
So the bigger lesson here is that investors should actively dodge bubbles and not buy into any new model at triple digit earnings multiples.
We had previously suggested the bonds as a "safer" way to play this. We are moving out of that suggestion as well as we have recently found some bonds yielding over 7% that we think are actually better real estate plays. SAFE's big bet on the floating rate side is making us uncomfortable even with the bonds.
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: The Big Bet