2023-08-09 06:30:00 ET
Summary
- Safehold is a unique type of REIT that only owns the land under operating properties and leases it to tenants.
- The equity raise on August 8 caused concern among investors, but it is expected to be accretive to shareholder value.
- The net cash flows from the use of the new equity are projected to increase significantly over time, resulting in increased value for shareholders.
The vast majority of REITs own real estate properties that produce operating earnings. Some, like Apartment REITs, operate the properties directly. Others, so-called Net Lease REITs, own operating properties but lease them to an operating company.
In contrast, Safehold ( SAFE ) owns only the land under operating properties. They lease this land to tenants who proceed to construct and operate structures upon it.
There are key, big differences from ordinary REITs. One is lease durations, typically above 90 years. The second is that the land and all the structures that Safehold never paid for revert to them in the event of default.
This makes Safehold a RINO, or REIT In Name Only. It also implies that one should examine the specific cash flows in order to find the value of its stock.
I will have much more to say about all this in a recently promised article. Today I only want to address the equity raise announced August 8. Right at this moment, the market hates it.
It also caused consternation among some of our subscribers, and undoubtedly among many retail investors. We discuss today why the use of this equity raise will be accretive to shareholder value.
The Starting Numbers
Through the equity raise, about 8M new shares (at $21.40) will be created, a ballpark 10% dilution of existing shareholders. The story from there is the usual one for any equity raise intended to drive growth. If using the capital raised increases the per share cash NPV by more than the implied dilution, then the issuance is accretive to per-share value.
[The boiler plate in the press release announcing the raise allowed for other possible uses of the funds. But I am confident from years of covering this company and many discussions with management that what they will do is use it to grow the ground-lease portfolio.]
We will assume that the total amount raised will be $160M, to have a nice round number. As is usual for Safehold, they will pair this with about $320M of new debt to add $480M to their ground lease portfolio.
Let’s start with the resulting revenues, focusing on cash yields. As of the Q2 report, the portfolio-averaged cash yield was 3.5%.
The cash yield has been moving upward. President and Chief Investment Officer Marcus Alvarado noted, in the Q1 earnings call, that:
"Pricing today, I'd say your cash yields are consistent with where we've been recently, so call it low-4s to mid-4s on a cash basis “
At 4%, the revenue produced by that $480M will be $19.2M. Most importantly, that revenue will escalate by 2% per year for 99 years.
The revenue will also be increased over time by the CPI lookback provisions in the leases. We will ignore that here but you can see how significant it can be on page 8 of this presentation . We will also compare lease rates of 3.5% and 4.5%, for reference.
It is notable that Green Street considers these revenues to have the security of AAA bonds. This reflects the severe financial costs of default.
There will be interest expenses on the $400M. In the Q2 2023 earnings call, Alvarado disclosed that:
"We have $500 million of swaps in place with SOFR locked at approximately 3% for five years, which is presently in the money based on current market rates. We also have $400 million of 30-year treasury hedges with a weighted average rate of 3.47%."
Rather than consider scenarios for swapping or hedging the new debt, here we assume that it will carry a 5% interest rate forever. This would cost them $16M on the $320M of debt.
This interest rate seems overly pessimistic to me. Even today, they could get to about there with their expected upgrade to an A- credit rating. The reason that they will get that upgrade is the extreme security of ground-lease rents, combined with the consequences of default.
The Outcomes
The above numbers underestimate the earnings and overestimate the interest costs. There are no other significant ongoing costs because the cost of running a ground lease is negligible.
Here are the resulting net cash flows produced by the use of this new equity:
It is notable that the initial $19M of rent increases to $135M by the end of the lease. In contrast, the interest costs do not increase at all, on our assumption that interest rates stay constant. One might seek to produce more value by refinancing at intervals and investing the proceeds, but again we ignore that upside here. [G&A costs are discussed later.]
The next step in finding a Net Present Value or NPV is to discount the cash flows shown to account for the time value of money. One takes the net cash flow for each year and discounts it back to the present, just as one does in evaluating bond prices or the NPV of mortgage payments.
Doing just that shows us how the NPV depends on the discount rate:
The three curves are for lease rates of 3.5%, 4%, and 4.5%, with the thick blue one being the nominal value of 4%. The dashed black line shows the cost of the dilution from the share issuance.
At current BBB+ discount rates near 5.5%, the outcome of the equity issuance nets to more than $1 per share of increased value for shareholders. If discount rates move about halfway back to their values in early 2022, that will become near $3 per share.
Other Costs
The only other costs here are G&A costs. These costs are guided to $50M per year for at least the next several years. What they support is placing new ground leases. The costs to operate the ground leases are negligible by comparison.
If you allocate 10% of that to the new tranche, that is $5M per year, which will decrease with further growth of the portfolio, dropping by perhaps half over the next five years. Even without portfolio growth, the net cash flows would exceed that $5M in year 5.
By then the net shortfall would be $3.3M (without portfolio growth), or less than $0.05 a share. On the previous plot that is negligible.
If you extend that $5M/year for the full 99 years, that would be 11% of the total net rent less interest payments. Also not enough to worry about.
Takeaways
The new tranche of ground leases enabled by the equity raise will be accretive to shareholder value under any reasonable assumptions. Understanding this does require understanding bond math, which I suspect many skipped in school because it is too boring.
The above modeling manifestly underestimates the NPV of the new tranche. Factors that will increase it:
- The CPI lookback additions to rents
- The likelihood of at some point reducing the interest rate
- The likely coming decrease in discount rates.
While Safehold has historically managed to have their cash lease rates marginally above their cash interest rates, that is not actually necessary for them to produce value. The reason is that the lease rates apply to the full investment while the interest rates only apply to 2/3 of it.
Instead, the point of having lease rates be a bit above interest rates is related to cash flow. If one does not produce enough near-term cash flows to cover current costs then one will need to add additional debt.
I will discuss cash flow issues in my coming, longer article. The bottom line there is that any (temporarily) needed additional debt would be small potatoes.
In addition, the board might decide in that case to reduce the dividend. The value of SAFE rests in the NPV of the ground leases. In some ways the dividend is a distraction because it encourages people to do irrelevant calculations.
In short, do not invest in SAFE for the dividend, no matter how high the yield gets. Invest for the present and future per-share value. Right now, SAFE stock is a steal.
For further details see:
The Safehold Equity Raise Will Be Accretive