2023-05-14 07:00:00 ET
Summary
- As most of my readers know, I come from the Benjamin Graham school of hard knocks.
- That means I've been taught that value in relation to price (not price alone) must determine my investment decisions.
- We all know that the most beneficial time to be a value investor is when the market is falling.
This article was published on iREIT on Alpha on May 13, 2023
SWAN is an acronym that stands for "sleep well at night."
I've been covering Safehold Inc. ( SAFE ) since 2018 and my very first article is called " Crack Open The Safe ".
Seeking Alpha
Not a bad call, right?
From that lens, yes...
But what about my article in June 2021?
Seeking Alpha
So, you tell me, do I deserve a victory lap (+89% total return since my first article) or be banned from Seeking Alpha?
I know the answer...
You're only as good as your last game, so since my last article in April, SAFE shares are +.89% (under-performing the S&P 500).
Seeking Alpha
Alas, if the stock was truly a bargain when it was purchased, the rationale course of action would be to take advantage of this even better bargain and buy more.
As most of my readers know, I come from the Benjamin Graham school of hard knocks in which value in relation to price (not price alone) must determine my investment decisions.
We all know that the most beneficial time to be a value investor is when the market is falling. So, when Mr. Market fails to fully incorporate fundamental values into share prices, an investor’s margin of safety is high. Columbia finance Professor Joel Greenblatt framed it this way,
“(the margin of safety) is about figuring out what something is worth, and then paying a lot less for it.”
Ground Lease 101
Safehold is a real estate investment trust (“REIT”) that specializes in ground leases. Ground leases are a little different than the normal property types we cover.
Rather than acquiring a commercial property, SAFE invests in the underlying land, leases the building for 99-years and has the future contractual ownership of the building at the end of the lease. Ground leases can play a role in several situations.
An existing building owner can raise capital for their operations by selling the land to SAFE and then leasing it back from them. This gives the building owner an infusion of capital to invest in their business, while SAFE locks up a long-term lease that is normally structured on a triple-net basis.
Ground leases can also be used when a property is under construction, or needs renovations, and the building owner cannot access the capital needed through their traditional financing channels.
In this respect ground leases are very similar to other types of leases that we cover since SAFE provides capital to the owner and in return receives long term rent checks.
Ground leases are also similar to the more traditional types of leases in that they have contractual rent increases, as SAFE’s are straightforward at a fixed rate of 2% annually plus CPI lookbacks every decade that are capped around 3.0-3.5%, which provides a nice floor to ceiling. However, there are some significant differences as well.
Ground leases are much longer than the typical lease. They typically range from 30 to 99 years and usually contain tenant renewal options . This is one reason why ground leases are compared to high-grade long duration bonds since they are structured over long periods of time, have predictable cash flows, and are secured by the structure that resides on the land.
To this point, if a business owns the building and they fail to pay the ground rent, and in addition the leasehold lender on the building who is subordinate to SAFE also doesn’t cure the ground rent, SAFE can take possession of both the land and the building. Additionally, ground leases contain residual rights which enables SAFE to keep the land and the building at no additional cost once the lease expires.
SAFE monitors the value of the land and property in its residual portfolio. As the property and building’s value exceeds SAFE’s cost basis, they report that amount as unrealized capital appreciation. SAFE cannot capitalize on this gain until the lease is terminated or expires, but at some point, both the land and any improvements on it will be in their possession.
In 2018 SAFE took an innovative approach to monetizing this potential future capital appreciation when it established its Caret program. This program set up Caret units to reflect the unrealized capital appreciation that SAFE expects to receive once the lease terminates or expires.
SAFE has sold ~3% of the Caret units to institutional third-parties (family offices, sovereign wealth funds, etc.) which entitles the holders of these units to participate in any proceeds that are above SAFEs cost basis once the assets are sold and the capital appreciation is realized.
SAFE has ground leases spread out across the United States. Based on gross book value (“GBV”), Manhattan is their largest market at 24% of GBV followed by Washington D.C. at 11% of GBV. No other market makes up more than 10% of their GBV, and they are diversified across gateway and growth markets
While location and long-term sustainable growth is their thesis, when measured by GBV, office is their largest underlying property type at 44%, followed by multifamily at 37%. Their smaller categories include hotel, mixed use, and life science which makes up 12%, 3%, and 4%, respectively.
Over time, SAFE has maintenance provisions and alteration rights if the leasehold owner wants to change the building to its highest and best use , which over periods of time consistently happens in real estate.
SAFE is investment grade with a Baa1 credit rating from Moody’s and BBB+ credit rating from Fitch, and both agencies have them on Positive Outlook, which is unique in this current market environment. They are rated as a Non-Bank Financial as opposed to a REIT , as they do not have typical real estate operations or asset management.
They do not have the 0-100% equity risk of managing, operating, designing, constructing, leasing, marketing the real estate. They have 0-40% fixed income risk as SAFE’s debt relative to their assets is reasonable with a debt to asset ratio of 60.18%.
Net debt to EBITDA is relatively high today, but is not as relevant for SAFE as other REITs, as SAFE is a capital provider without any property obligations such as capital expenditures that reduce free cash flow (that is the leasehold owners responsibility), and SAFE has the longest debt maturity profile of any company.
For their business, creditors typically look to debt yields and look-through LTV’s at maturity (not next quarter or year) as they do not have debt rolling year-to-year like other operating real estate businesses, and in 30-years when SAFE’s typical debt comes due, their cash flows will have compounded substantially.
SAFE has a total debt to book equity ratio of 1.9x and a total debt to equity market cap of 2.3x. However, they have an extremely long weighted average term to maturity of 23 years and have no maturities due until 2026. Additionally, they have $900 million available to them between cash on hand and the undrawn capacity under their credit facility.
SAFE has delivered impressive earnings growth since they went public in mid-2017. Since their first full year operating as a public company they have an average annual earnings growth rate of 37.40% . They have increased the dividend each year as well, albeit at a much slower rate of 3.56%.
SAFE pays a 4.87% dividend yield that is very secure with a payout ratio of 31.22% based on their net income. This metric has improved dramatically since 2018 when the payout ratio was 93.75%. The payout ratio has fallen each year, no doubt due to the rapid earnings growth against the moderate dividend increases.
SAFE 10-K (compiled by iREIT)
Valuation...
Finding the appropriate valuation for SAFE is somewhat challenging since they don’t have any direct peers that operate as a pure-play ground lease REIT and they have a fairly short history as a publicly traded company. Below is a chart showing their price action over the last 5-years.
One thing I’d like to point out is that they are currently trading at a lower price than they were in 2018 , but their net income per diluted share has increased from $0.64 in 2018 to $2.21 at the end of 2022. On this basis, the stock is trading at the most attractive valuation since going public.
Additionally, they were externally managed up until their recent merger with iStar that internalized their management . Transitioning to an internally managed REIT should be a positive catalyst for a host of reasons, as the company begins to educate investors for the first time post-merger and coming out of earnings season.
Safehold has equity research coverage from both REIT and Financials analysts, given the hybrid nature of the business.
A report published by BNP Paribas set a price target of $46.00 , using a multi-prong valuation approach including NAV, AFFO Multiple and DCF of future cash flows with a $2.4 billion Caret valuation, in line with MSD Partners recent investment at a $2.0 billion value.
REIT dedicated analysts have come in lower, including a recent report published by Mizuho Securities with a price target of $31.00 , representing a 10.3% upside from where it is currently trading at today.
BNP
Mizuho
Maybe the best indicator of its valuation is what the insiders think, in particular the CEO Jay Sugarman. Since May 3 rd the CEO has made 4 separate purchases for a combined 4,300 shares at prices ranging from $26.62 to $28.21. No one knows SAFE’s business better than its CEO and he seems to think the stock is currently trading at an attractive valuation.
SAFE is very sensitive to changes in interest rates and inflation due to the long duration of their leases. Cash received 30 or 99 years from now is worth much less in the present, especially when discounted back at a higher required rate of return.
I think a large part of the stock's decline over the past year and a half is due to the sharp increase in interest rates and inflation, but I also think SAFE will outperform once the pendulum swings back the other way.
In addition, if they could also get investors to see the CPI capture, they will contractually get in their leases, the value of their long-term fixed rate liabilities, and the progress and value of Caret (MSD recent valuation of $2.0 billion), these could add even more upside on top of rates changing.
At iREIT we rate Safehold a STRONG BUY.
Seeking Alpha
Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
Safehold: The Ultimate SWAN