Safehold Inc. (SAFE) Earnings Call Transcript

Okay. Good afternoon, and thank you for joining us. I'm Barclays Consumer Finance Analyst, Mark DeVries, and I'm pleased to be joined by iStar and Safehold's Chairman and CEO, Jay Sugarman. Jay has some prepared comments to deliver, which will be followed time permitting by Q&A. [Operator Instructions] With that brief intro out of the way, I'll hand it off to Jay. Jay, the floor is yours.

Thanks, Mark. Thanks for having us today. Thanks, everybody, for joining. The iStar story has become very interesting over the past 18 months. We've really done a lot of work to both simplify the balance sheet to strengthen it and also to scale a brand-new business that's a very exciting one and will really be the driver of value at iStar going forward. So we wanted to spend a little bit of time today just going through those 3 components, but spend most of our time really talking about this new business, Safehold, and some of the very exciting success we've had to date and what we think the opportunity is going forward. So let me take you to Page 3, which we'll just be a relatively simple recap of some of the steps we've taken as part of this 3-part strategy to really build the future of iStar and something quite exciting. So Page 3, if you would. Next page, please, there you go. You can see here, over the last 18 months, we've really announced a new strategy that would begin with a strong foundation. And that foundation was predicated on continuing to strengthen the balance sheet. You can see some metrics here between Q2 '19 and Q2 '20. More unencumbered assets. Stronger UA/UD ratios. Less leverage and unsecured debt continuing to be a core component of our balance sheet. It gives us a lot of flexibility, a lot of strength to really build the go-forward business on. That was recognized by Fitch recently with a positive outlook. We think this is a continuation of a trend over the last several years of iStar really gravitating to a higher and higher credit. If we go to Page 4. We can also show you some of the dynamics inside the portfolio of businesses we run that is really also improving the strength of iStar. And we'll talk a lot about SAFE, which is our new ground lease business, some of the highest-quality assets in the real estate world. That is a component that has grown very materially. You can see that on the bottom of Page 4, growing from relatively small number 2 years ago to almost $2 billion today. In the meantime, the legacy assets, some of the more time-intensive, some of the higher beta assets have continued to shrink. So you're really seeing a shift into high-quality, stable assets out of the higher, more time-intensive, higher beta assets. So the overall portfolio quality also growing nicely. So both the liability side and the asset side have both improved materially and really create a foundation for our go-forward strategy. So let's take a look at the overall business today. You can see on the upper left-hand portion of this page. I think that's Page 5. Net lease and SAFE, which is really ground lease, a subset of net lease, make up almost $4 billion of our $5.5 billion balance sheet. This is the direction the company is going. Ground leases will be our future. We've said that publicly over the last 18 months. And I think what you see is between the diversity of the balance sheet, the strength of the major business lines, the performance, as you see in the upper right-hand quadrant, has been very strong even through the downturn. That diversity, that focus on this go-forward ground lease business has really put us in a -- quite a strong position. So let's talk about that go-forward business. As we look on Page 6, we just tried to summarize some of the key highlights of Safehold. First, if you look on the left-hand side of the page, you can see the growth in the investment by iStar into Safehold. We started the company 3 years ago. We were the -- we contributed the initial assets. We're the largest shareholder, we're the investment manager. So this was always intended to be a growth strategy for iStar. I'd like to say we're a buyer, not a seller, as part of our view of Safehold, and we continue to add to our position as you can see today, not only have we grown our direct investment, but the value of that investment has materially increased over the last 12 months, combined almost $1.2 billion increase in total investment in Safehold. Why is that a good thing? Well, you can see from the metrics on the right. Ground leases do represent an extremely predictable long-term cash flow stream. We've received a 100% under our ground leases during this difficult time. They've now grown a portfolio of almost $3 billion at Safehold, and that continues to be just in our minds, early innings in a very big business opportunity. We've also capitalized Safehold with a lot of dry powder, about $900 million of purchasing power today. So as the markets and transactions do pick up, we think Safehold is very well positioned. I'm going to spend a few minutes just talking about the Safehold story because if you're investing in iStar today, you're investing in our Safehold story. We said about 18 months ago, our Board had approved making this the core focus, the core mission of iStar. And there's a reason for that. As you see on Page 7, we think this is just a better solution for the commercial real estate markets in terms of capitalization. And we say that with quite a bit of confidence because having been in the finance business for over 2 decades, the net lease business for over 2 decades, we see very clear parallels between the advancements we were able to be part of in the finance world, the advancements we were able to be part of in the net lease world. There is no reason ground leases should not follow the same trend. This is a better, more efficient solution for users of capital. We break that down into 3 simple reasons: one, the capital efficiency argument is very analogous to the net lease world. So if you think about a building, it's really 2 investments. It's one, very stable, very low beta, long-term investment, which is the land; and one, management-intensive, typically shorter-term hold, high ROE asset, which is the building. And most CFOs of most corporations in the last 20 years have figured out that holding lower risk, lower management capability assets in the same vehicle as the operating business rarely makes sense. And we've seen that in the real estate world, the data center operators now still lease back their data centers. You've got cell tower operators, they lease back their cell towers. Everybody has figured out that these 2 investments are very different. These lower beta, different management skill set assets are separated apart to create more capital efficiency. And in our case, separating the building from the land just makes incredible amount of sense. These are very different return profiles, very different risk profiles, very different management skill profiles. They really shouldn't be together. And only because there has never been a nationally scaled institutional player like Safehold to provide this capital in a new modern form that this efficiency has never been captured by owners of buildings. So we're providing something that probably should have existed a while ago. Certainly, over the last 2 decades, we've seen every major part of the real estate markets get more efficient. This is one place we still see a major inefficiency. And with that simple step, with that simple, hey, these 2 investments don't belong together. We also are able to benefit owners in 2 other material ways. One is, every time a building and land together traded either in a sale or refinancing, that entire capital stack typically gets hit with some friction costs. Transfer taxes are based on the total value of the transaction, mortgage recording taxes, title insurance, brokerage fees, all of those are tagged to the size of transactions. Well, about 1/3 of the capital structure of every real estate deal really never changes hands. That land should just sit in a stable ownership position, and that friction cost should be about 1/3 less. So ground leases are going to unlock a lot of capital efficiency that are also going to unlock a lot of cost efficiency. And then as most of us know, the real risk in the real estate world is driven by debt and leverage. If you look on the far right-hand side of Page 7, we think ground leases actually reduce that risk very materially. So taking a typical $100 million building and land assemblage. You have a borrower who wants to go out and borrow $70 million against the land and the building, they're probably going to have a maturity date in 5, 7 or 10 years. And that is the risky day, not being able to pay back that maturity has really been the signature of real estate risk. If everything was equity financed, there probably wouldn't be a lot of real estate risk in the market. So leverage is something that you have to be careful with. What ground leases do is take about half of that leverage and turn it into almost permanent capital, 99-year capital, no maturity. So instead of $70 million coming due in 5, 7 or 10 years, you now only have about $35 million. Your maturity risk has fallen in half. So more capital efficiency, more cost efficiency, material risk reduction. We think these generate about 300 to 500 basis points of incremental IRR for building owners. We've seen that in a couple of transactions, and it's proven true across a pretty wide range of asset types. We know that cost efficiency is real, and we know that risk reduction is real. So higher returns with less risk that's a formula for building a very big business in the real estate world. So how is it going? Let's look at Page 8. This is a new business. We are a pioneer. We are reinventing ground leases. There's a long history of bad ground leases doing bad things to values. We are just building the new modern era where good ground leases actually add value. And you can see the take-up started out a little slow. People were skeptical. Can this really work? It makes sense. It's very logical. You're right. The corporate world has been doing this for decades. It looks like it reduced cost, it looks like it reduces maturity risk, but I don't want to go first. I want to see somebody else do it. And we started out really just educating, really helping brokers, owners, developers, people in the market to build assets, refinance assets or purchase or sell assets. We said, look, just let us show you why this is so compelling, why it's so logical, why the common sense here really is different than what you might remember from some of those bad ground lease examples you're probably thinking about. And we started to grow, and we started to break into markets. And once we broke into a market, we started to see a lot of peers and colleagues go, wait a second, that looks like it works really well, let me see it too. And the more markets we penetrated the faster growth went. And so what you see here is really a chart showing in the top 30 markets that we target, we've probably penetrated about 2/3 of those. And as we grow and as people get more familiar with what we're doing, we see more take-up of the idea, a little less resistance. And we think this is really, again, just the beginning of creating an entirely new way to think about the ground lease industry, the real estate capital structures that are most appropriate. And we think that commercial real estate addressable market in the top 30 markets is something on the order of $7 trillion, which means there could be as much as $2-plus trillion of ground lease potential. So again, first and only public company doing it, really the first and only company with the idea that modernization could be a revolution. But more important, somebody like iStar that knows the finance business that knows the purchase and sale investment markets, we are perfectly positioned to be the right provider of this capital. We are lender, we know what lenders need. We are a buyer and seller real estate. We know what buyers and sellers need. So we've taken a lot of the frustration, a lot of the -- does it really work? How do you do it? Who would you go to for a leasehold loan? We're now $3 billion deep into it. We can make this a very simple and streamlined process for folks. And I think the idea for us was not simply to help our customers, our building owners generate returns, it was to share in that benefit and really create a unique investment vehicle for investors. We know shareholders have never really had a chance, or investors broadly have never really had a chance to buy into a world-class modern ground lease portfolio. We also know people are well aware that institutionally, some of the wealthiest investors in the world do own ground leases. Churches, universities, monarchies have all built tremendous wealth by owning typically ground leases in a single location. But there's never been a way privately or publicly to invest in a company that owns a top-tier institutional-quality, diversified business that does for a living new ground leases every day and provides capital as a thoughtful partner to building owners around the country. So this is a new place to invest. And we think it's a really exciting one. And we'll show you now beginning on Page 9, why that's true. First and foremost, in these difficult times, ground leases and the portfolio that Safehold has created really has some of the best principal safety out there. And we show that to you on this slide by making the analogy where we sit in the capital structure and where typically, the AAA tranche of CMBS sits in the capital structure. And you can see AAA CMBS is typically 0% to 35% of the capital structure. And Safehold's ground leases are probably in that 0% to 35%, 0% to 40% range as well. So we start with the premise that this is the very safest place in the capital structure akin to AAA. We like to say the storms hit the surface of the ocean, but deep down where we are, it's pretty quiet. And on top of that safety, if we go to Page 10, we have something else that I think is really attractive. We fundamentally believe that compounding returns is the most powerful wealth-creating force in the investment world. Ground leases are ultra-long investment vehicles, typical maturity is 99 years out. And there are other assets that also have that dynamic. There's a part of the fixed income world that has 100-year bonds in it. And we see and track those every day, and they trade around today about 3%, 3.1%. But if you look at the blue line on Page 10. A ground lease not only starts in the same sort of return, which is an attractive place to be today, but it grows at about 2% a year on average. And typically, that's a contractual growth curve. So while the bond that you buy for 100 years from MIT, very safe, comparable risk, comparable maturity, is at 3.1% every year for 99 years. We start in the same zone and start growing and start compounding, and that compounding continues to add value. And what you see on this chart is that blue-hashed area is what we call the excess returns from ground leases that we create. And today, that's about a 5%, 5.5% yield-to-maturity against long-term comparable quality, comparable maturity bonds in sort of the 3%, 3.1% range. This is really important. In the high-grade world, and particularly the AA, AAA world, if you can beat the benchmark by 25 basis points, you really excelled. We think we're creating a business, and we've spent a ton of time and a ton of money building it. So it hasn't been easy. But now that we've got it going, we think we're generating hundreds of basis points of excess return. And we can tell you what that feels like and what that's worth, using some simple bond math, what it tells us is for every time we do a deal, we're creating tremendous value, tremendously accretive value. And again, in a very competitive world, in a very high beta world to create low beta, excess return, real alpha and have it compound for a long time. Well, that's why I think you've seen the share price performance at Safehold. But we would argue there's more to come. So that component, pretty simple. You can run the simple bond math, you can figure out what our assets are worth once we create them. We've got a sizable team out there working every day. We've got tremendous intellectual property from being the first player out there. We probably looked at a 1,000 deals. We've probably reviewed 1,000 bad ground leases. So we've built real intellectual property competitive advantages, and we think we can easily show the value creation here on Page 10. Page 11 is something interesting that comes with that story. And we have really talked a lot about it. We will talk about it in the future once we really reach full scale, which is still a little bit of a ways away. But remember, a ground lease not only pays you rent for that 99-year term, but at the end of that, you actually own the building on top of the land, i.e., the lease has ended, and the building reverts back to the landowner. And what we like to do is track that what we call built-in capital appreciation for you. And this is a really powerful concept because if you look at this curve, you saw the portfolio growth curve. You saw the rent curve, and now you see this embedded capital appreciation curve. And they're all bending up very quickly. They're all compounding. And so what you see on Page 11 is really a snapshot of what that baked in embedded capital appreciation is today. We're not guessing what values are going to be way out in the future. We're just using third parties brokers to go out and tell us what is that baked in capital appreciation today? And at just over $5 billion today, about 50 million shares, you can do that math and realize not only are you getting a very attractive cash flow stream when we get a ground lease done, not only are you getting the portfolio growth that we're building in by being the first, really the inventor of this concept, you're also getting this long-term wealth-creating capital appreciation build-out. Those 3 components are really interesting. And as we scale the business, we'll be able to show you that while they would be interesting for a single-ground lease and are somewhat interesting, that really isn't the business. There are dynamics in single-ground leases that are quite nice, but they don't really create the same kind of wealth that we're trying to create for shareholders. It's only by building a nationally scaled institutional quality diversified growing platform that you can start taking advantage of some of these other dynamics. And that's what we'll spend 2021 certainly talking to the market about as we've reached this $3 billion, $4 billion range. We think we've reached an institutional scale where we can really start talking about some of the nuances that we think we figured out that are very different than just owning a single ground lease. That math is not quite as compelling to us. But we'll share with you over time, once we get the market to really even understand the bond math here that there are some other pieces of this puzzle that are equally exciting and really are driving why iStar is making this a strong move to build this business and scale it quickly. But I'll leave you with Page 12, which really encapsulates some of the progress we've already shown. And again, iStar as the manager and the largest owner, we own about 65% of Safehold shares. You'll see why even these early successes, even this early success in the ground lease world is starting to translate into material value for iStar shareholders. On the left of the page, we just show you our common equity per share. Over the last 12 months, you can see it's grown almost 70%. We think the right metric is probably more on the right side of the balance sheet, where you add back depreciation and amortization mostly. You've seen we've gone for about a $16 adjusted book to almost $26 -- over $26 adjusted book against the share price that candidly does not reflect these values. And I think this is where the opportunity exists to help people understand that simplification, that strengthening and the Safehold story. If we can do a good job of those 3 things, I think we'll close this gap pretty quickly. So Mark, that's the quick overview of SAFE and -- iStar and Safehold. Happy to sort of answer any questions you might have.

Okay. Great. Thanks for those comments, Jay. First question for you. There's been no shortage of speculation on the future of commercial real estate and COVID's lasting impact on cities like New York. How do you think about investing in this context, given your target is commercial real estate in the top 30 cities?

Yes. No, this is a difficult period to underwrite in. There are clearly changes going to take place. But one of the fortunate things is we think in decades, not quarters. I know you're not allowed to do that, but we can. And so again, investing where we invest at, we're thinking long-term dynamics. And what we found is the great cities remain great. They adapt, they change, but they're there for a reason. We see the Londons, the Parises, they don't go away, but they do have to adapt. And we're pretty sure that the great cities of the United States will do that adoption as they've done before. So we're still looking for well-located, high-quality, sponsored assets. And we don't think there's going to be any shortage of those opportunities as capital -- efficient capital becomes even more valuable. So I would say our long-term view on the United States is still very, very positive. Our short-term view is we're going to try to help people get through this with some of the most efficient capital out there. But everybody is going to have to really dig down deep and adapt and get through this together. So really, no doubt that the long-term success of well-located real estate is still a great place to invest. We're doing -- our top 30 markets include a lot of fast-growing southern markets, but we still believe in the financial centers, the technology centers of this country long term. We're going to continue to invest there and help those building owners access this new modern capital structure we've created.

Got it. So you've talked a lot about modernizing ground leases. Can you talk a little about how your ground lease solution is different from the traditional ground leases that exist?

Sure. And this is where the parallels to the, I think, the real estate finance market in the early '90s in the net lease market in the early 2000s come into play. One of the things we know is the modern finance and investment markets hate uncertainty and ambiguity. If you are asking lenders or buyers to underwrite the unknowable, you're going to get a worse price. And so one of the things the old ground leases did that was really terrible and has actually destroyed value for many people is they put in these things called fair market value resets. They put in all sorts of ambiguous provisions where it wasn't clear what would happen in certain outcomes. And when you think about the modern markets, if you tell somebody that their rent is unknowable, they're going to pay you a lower price. They're going to underwrite to their worst-case scenarios. So a lender or a buyer is looking at a ground rent that they have no idea what it's going to be. The answer is not going to come back very good in terms of what they'll lend you, what it will be priced at or what they'll buy at. So the first thing we did was just take that out. That is a nonstarter for us. Creating very simple metrics that are easily understandable, not just for our customer, but anybody looking to finance the project or the building, anybody looking to buy it. Very simple. And then we take the next, what I would argue, 25 provisions in ground leases and modernize them. All the pieces from how do things work, how does insurance work, what are all the rights. Simplify them. Make them easier to understand, easier to work with. And then put that all in the package of an iStar, which sees itself as helping our customer make more money. And that's a profound shift from the old ground lease structures, which are typically a land owner saying, these are my terms, take them or leave them. None of them are really have to be in the customer business. If you're MIT and you own a bunch of land, people are coming to you. That is not our business. Our business is to go throughout the country and say, this is a better mousetrap. You will make higher returns at less risk. We want to work with you, not against you. We want to be unlocking value, not destroying value. That is so different than the whole mindset that the ground lease business has historically been done in. And I think it's really going to be a revelation to a lot of building owners when we come in and say, here's how to unlock value. Here's how 1 plus 1 equals more than 2. And we don't expect people to do this if it doesn't make them more money. So we wouldn't even be doing this if we didn't believe it is a better mousetrap. We pressure tested it on iStar's assets. We tried to sell them, it's be simple or taking these 2 different investments splitting them, and we found we were getting about 10% more money by splitting more efficiency, easier to value. And so I think what you're going to see over time is people are going to realize that the old ground leases have nothing to do with what we're doing. The fair market value resets, the ambiguity, the uncertainty has all been worked to be eliminated. And now this new modern ground lease can be a real tool. Whether you're developing an asset, whether you're refinancing an asset, whether you're buying or selling an asset, you should at least know what the alternative quote is from splitting your building and your land apart because you may find out you can get a lot more value than you thought by just taking advantage of these efficiencies and eliminating the inefficiencies.

Makes sense. Thanks, Jay. You've discussed that COVID has resulted in lower ground lease originations. How do you think Safehold's ground leases fit into today's market environment? Do you think that growth can continue?

Yes. Look, we definitely think we will get our fair share of transactions. We just -- we know this is a better mousetrap. And the more we educate, the more deals we're going to get. So I don't think it's a calculus other than the more transactions, the more business we will do. COVID has obviously clamped down on transactions in real estate, both purchase and sales and financing. So we're continuing to educate, we're continuing to do deals. But the take-up that I think people will really get excited about may take a little longer. It started last year. We absolutely believe this is just a function of the COVID timeout in the real estate transaction market. And as soon as things pick up again, which we know they will, we're going to be standing there even having been able to spend more time educating more customers. And we're doing transactions right now that tell us this is a better solution. I just think some of the biggest transactions, the people are kind of sitting, waiting, watching. But we're doing quite a bit on smaller transactions that tell us nothing. Nothing suggests this isn't going to continue to be a wave that we're going to be out in front of.

Sounds good. I do have a question that came in from one of the investors listening in. The question is, how should we view the negative implied value of iStar's stock excluding the current market value of the company's stake in Safehold?