Description

“Just like yesterday, then I’ll get on my knees and pray – We don’t get fooled again. Don’t get fooled again, no, no.” – Pete Townshend, The Who

Investment Summary

iStar Financial (STAR – NYSE) was a poster child for the 2008 financial crisis, offering a complex assortment of mezzanine real estate financing, in addition to securitization of different portions of real estate mortgages and leases. The stock price thrived despite limited disclosures and opaque accounting, until collapsing from $50/share to under $1/share at the low point in 2009. The company survived, but had been range bound in the $10-$12 range until its newest iteration promising to “revolutionize” the real estate industry was taken public in 2017. Safehold Inc. is a Maryland REIT that was formed to operate iStar’s land leasing business. The company has been highly promotional in advocating their ability to “disrupt” the real estate industry with their ground lease “platform.” Despite the merits of land leases (for owners) the company is at least 50% overvalued today (at ~2.2x book value), and quickly approaching its limits to growth. The sponsor (iStar) is highly incentivized to grow the equity of the company in order to increase fees, which has resulted in a higher risk, lower quality portfolio. While iStar maintains a 2/3 ownership in the company, the management and incentive fees extract much of the REIT value back to the sponsor (including a newly formed “CARET” to pay incentive income to management). Finally, the portfolio is not as “risk-free” as their marketing materials suggests, with nearly 10% of gross book value in a hotel portfolio (Park Hotels) with percentage rent based ground leases, and over 10% of cash income being derived from a hotel (Double Seattle Airport) in which Safeguard is ultimately a ground lease tenant (and will likely surrender the property). For these reasons and more, I believe that Safeguard will decline to book value or less within the next 6-12 months.

Background

Ground leases, as the name implies, are leases of the land which sits beneath many operating properties. These leases are often very long-term (i.e. 99 years) at origination, and a modest portion of the property owner’s operating expenses. The ground lease sits senior to any other encumbrances on the building, and often hold various rent escalators and “fair market value” and “highest and best use” adjustments. This has led to great confusion (and capital loss) for property owners that are not savvy to these nuances, as evidenced by the Abu Dhabi Investment Council’s experience with iconic Chrysler Building in New York City.

A strong market for ground leases has recently developed as wealthy families and institutions with unlimited duration are eager to acquire these leases, and potentially own the property upon the ground lease reset. The ground lease owner has generally no obligation to renew a ground lease upon expiration, and can take possession of the property and equipment upon expiry at no cost. The economics are particularly attractive when there are fair market resets, which accelerate property transfer. The demand for these instruments is a product of increasingly low capitalization rates on quality stabilized operating properties across the globe (pre-COVID) and a lack of sources of investment income. As such, these leases have largely been bid up to extremely tight capitalization rates. In any event, land lease can potentially be low risk, ultra-long duration investments with significant asset value recognition upon lease reset or expiration – if they are structured properly and owned at the right cost basis. 

Safehold Inc.

Safehold has developed a “platform” to grow its portfolio of ground leases purporting to “modernize” the archaic ground lease structure. The websites for both iStar (link) and Safehold (link) are extremely promotional citing a “revolution” and “ground breaking innovation” that is “disrupting” the commercial real estate industry. They claim to be more capital efficient, cost effective and reduce risk within a $7 trillion “institutional quality” market – none of which are inherently untrue. However this hubris has led to a misperception of limitless accretive growth for the portfolio – the vast majority of which was been recently acquired – which is currently trading at over 2x book value. The company also makes use of creative terminology such as “Combined Property Value,” and “Owned Residual Value” to portray misleading measures of current company value. There are also various nuances to their stated yield spreads related to cash yields (3.5%) and effective yields (5.5%) that obscure the fact that the current spread of leases underwritten at 3%-3.5% are at a break-even or negative spreads to mortgage debt at a weighted average of 4%. These underwriting spreads are gross of escalating management fee on the portfolio equal to 1.5% of total equity (up to $1.5 billion) and the newly created “CARET” which entitles management to earn what is essentially an added incentive fee of 15% of the capital appreciation above the ground lease cost basis. Even if the portfolio were to be exceedingly high quality, which it is not, the economics at Safehold are largely funneled to the sponsor/management, and highly unattractive to property owners and developers (who they rely upon for new lease sourcing and growth).

Illustrative Lease

Although the company doesn’t provide any leasing specifics, they refer to standard underwriting at 3% cash yield at inception, with a standard 2% annual escalation, which equates to a 5.5% effective yield based on aggregate gross book value. The leases will then have “Inflation Adjustment,” which suggests that if inflation exceeds a certain hurdle, the escalators are adjusted. The company also presumes they will simply not renew the lease upon expiry, and take possession of the property. The chart below illustrates this simple rate progression;

This will result in the annual payment increasing to approximately 21%/year by the last year of the lease (year 99), at which point the fair market value will reset. If the ground lease is equal to 35% of the total property value, the total “cost” of the ground lease will remain at consistently 1.05% of market value. The “effective yield” is calculated by solving for an internal rate of return with the original cost basis paid back upon lease expiry. In the example above, this equates to an “effective yield” of 4.83% compared to the up-front cash yield of 3%, assuming only the cost basis is recaptured at expiry. However, if we were to assume that the property value increased commensurately with the 2% lease escalator, and the company realized the full value of the property upon expiry, the IRR would increase to 5.27%. A hypothetical 99 year lease at a 35% LTV of $1 million is present below;

This illustrates that despite a theoretical pickup of >$19 million at expiry, the IRR is still only 5.27% because it’s not realized until 99 years after the lease. Furthermore, at a 3% initial cash yield, and 2% escalator, a newly issued lease doesn’t cover the effective cost of the mortgages debt until year 15. Hence, the SAFE business model is highly dependent upon new equity capital for “growth.”

Current Portfolio

The current portfolio is not as risk-free as the company suggests – recent presentations compare the ground lease to the M.I.T. 2116 “100 Year Bond” with a fixed yield of 3.689%. Nearly 10% of gross book value, and over 17% of 2019 revenue is in the Park Hotels Portfolio, which is a percentage rent portfolio. This equates to direct operating exposure to these hotels, which are severely impaired currently during the COVID shutdowns, with highly uncertain recovery scenarios. The majority of this hotel portfolio is in the Doubletree Seattle Airport hotel (11% of 2019 cash income), which Safehold holds the ground lease for under a master lease of five properties, is under a ground lease held by a 3rd party. In the event that this party chooses not to renew the lease in 2044, the property value is relinquished (along with all rents and unrealized capital appreciation). 

The other notable properties are 135 West 50th Street and 425 Park Avenue, both of which are currently under construction, in New York City and comprise nearly 25% of gross book value. The latter property is held through an interest in a subsidiary REIT, which Safehold doesn’t have sole discretion over.

On an aggregate basis the portfolio is approximately 63% office, 19% hotel, 17% multi-family and 1% other. The weighted average remaining lease term is 89 years with an effective yield of 5.5% and a cash yield of 3.5%. 

Capital Structure & Valuation

The company is currently capitalized with $1.2 billion if equity and $1.7 billion of debt. The debt has a weighted average cash interest rate of 3.1%, versus a 3.5% cash yield, or a 0.4% spread. The debt has a 4% effective interest rate, versus a 5.5% effective yield on the portfolio, or a 1.5% spread. The tight spreads, and inherently low return on assets, results in a modest return on equity of approximately 3% - 7% (see below). However, at today’s value of 2.2x book value, the “buy-in” ROE or yield is 1.4% - 3%. It should be noted that this doesn’t include the 15% incentive fee on capital appreciation which accrues to the CARET.

Summary

The concept of a ground lease sounds very attractive to an investor that wishes to preserve generational wealth and maintain purchasing power. However, the promotional management at iStar and Safehold misconstrue the benefits of their ground lease model, which is easily exposed when calculating a simple IRR and assumed property transfer value. Furthermore, much of the economics accrue to the management team through an escalating 1% management fee and a 15% capital appreciation transfer to the CARET entity. These fees heavily dilute an already modest investment return. Finally, the portfolio is not pristine, with heavy percentage rent exposure to hotels, exposure to development projects, and is likely to lose over 10% of cash income in 2044 when the Seattle Double Airport reverts to its ground lease holder. 

The company is currently trading at approximately 2.2x book value and a 1.2% dividend yield, likely due to i.) retail investors ii.) index inclusion iii.) strong relative performance to REITs. I believe that the “growth platform” is deeply flawed, which will be obvious once the ability to source new leases slows down or even ceases. Growth is further predicated on equity issuance, as underwriting spreads to debt is too tight and all income must be distributed under the REIT structure. As such, I believe an appropriate interim valuation for the company is approximately 1.0x book value, or 56% downside.

Catalyst

- Inability to source new ground leases

- Inability to raise new equity 

- Debt/Income mismatch with % rent hotel portfolio suffering