Safehold Inc. (SAFE) Earnings Call Transcript

Good afternoon. We made it, or at least I made it. This is our last but certainly not least panel of our fourth annual series symposium. We are finishing with the fireside chat with Jay Sugarman, Chairman and CEO of Safehold and iStar. It wouldn't be a panel discussion without our standard disclosures. For important disclosures, please see Morgan Stanley research disclosure website. If you have any questions, please reach out to your Morgan Stanley sales representative. So Safehold's mission is to revolutionize real estate ownership by providing a better and more efficient way for owners to unlock value of the land beneath their building. The company identified a widespread market inefficiency and set out in 2017 to redefine how real estate is owned. Their diversified expertise enabled them to create a customer-friendly, value-enhancing ground lease platform for the first time ever. Safehold ground leases are designed to leasehold lender-friendly while not impacting future cap rates, I think an important point that Jay will talk about. Modernizing for today's real estate and financing markets, Safehold ground leases help customers build buy, sell and recapitalize all types of commercial properties within top 30 MSAs of the United States. So Jay, hopefully, I did that a service, but thank you for joining us.

Thanks, Richard.

I want to maybe start big picture. How big is the ground lease market today? And what's your market share?

Yes. So we did quite a bit of research about 5 years ago and not surprisingly there is actually very little research out there. So we had to kind of go through every major municipality and pool ground leases to try to figure out the answer to your question. We think it's about a $100 billion market today out of the $7 trillion of commercial real estate that we think comprises sort of the top 30 marketplace total. And we're probably, at this point, certainly the largest by orders of magnitude over anybody else. We are the only public company, the first institutional quality national platform. By the end of this year, we'll probably have done about 100 ground lease transactions, which, again, I would probably say is 5 to 10x more than anybody else in the market. But we think this is really the beginning of this modern ground lease industry. And when people ask us how big can it be, we look at the net lease business and what it's done for the corporate world, really trying to capture the same efficiency that we're trying to capture for commercial real estate, and that's $1 trillion industry. So we think there's a very, very significant potential ahead.

Yes. That's a big number. And so when you talk about $1 trillion, is that 5 to 10 years from now? Or is that even bigger. And so I guess what I'm really asking you is can you walk through your growth over the past since -- well, call it, since 2017. My sense is that you've really grown your portfolio. But what's the CAGR, what's the doubling. Can you walk us through that?

Sure. So we started out with a about a $300 million portfolio of ground leases that we had acquired over time, really testing the waters. It's a very interesting world that very few people had looked at. And frankly, we kind of put them on the shelf and haven't thought about it. Really around 2016, when all the sort of bolt of lightning moments where you see all the pieces lined up, we realized that if we could not only make the customer proposition a lot better than the historical ground lease business, but actually created for the first time a chance for investors to be able to invest in this incredible wealth-creating asset type, but make it public, make it liquid, diversify it, give it growth, then we would be on to something really important. So we've grown from about $300 million to over $3.5 billion now. So a tenfold increase since our IPO a little under 4 years ago. We think the opportunity set is enormous, Richard, I mean, our constraints are our people and the time we have to educate customers who, frankly, still many of them think about ground leases in the context of the old broken ones and how much damage a bad ground lease can do. So we have to kind of turn them around and show them how much good a good ground lease can do for them. And that's really been the mission for the first couple of years is really just to educate, show on paper and then show in real transactions, how we can generate higher returns with less risk for our building owners and then turn around and aggregate all of these ground leases around the country, and show shareholders why owning a piece of Safehold is not the same as just owning a single ground lease. It's materially better. It has some incredible wealth-creating components that I think most of the market is just now beginning to figure out at least some of the story, and there's a big part of the story to come. So feel like we're in the early innings, but already have grown sort of 10x and have publicly said to the market, we expect to grow another $3-plus billion in size over the next couple of years. We want to double over the next 3 years from the $3.2 billion we were at coming into 2021. So $6 billion, $7 billion, $8 billion, $10 billion is certainly in our near-term future.

Yes. So there's a lot to unpack there. But before we go there, I want to come back to your comment about early innings of institutionalization. I was speaking to an investor a couple of months ago, and they were asking me which asset classes are in the early innings of institutionalization. I said SFRs. And they immediately said, you are going to see nothing unless you looked at the ground lease business. So I guess that's a shameless plug to a degree. But I guess the question I'm ultimately asking is, if you're right, there's going to be more competition that comes into the ground lease space. Is that a good thing or a bad thing in your eyes?

Yes. Look, we've loved having most of the playing field to ourselves. Inevitably, we want to make this a mainstream product. So there's going to be other players. And certainly, there's room in $1 trillion potential market for others to join and then really help this revolution take place. Our only concern a little bit is that people sort of don't understand what we're really doing that this is a customer business, but they don't build it properly. A lot of the bad ground leases in the past. If you improperly size it, improperly structure it or improperly price it, you're actually going to damage the building owners' returns. So as long as everybody joins the party in a very disciplined basis and understands what we're really trying to do is unlock tremendous value for our customer set, which is the building owners, as long as that's the focus, the more the merrier. But we've spent 4 or 5 years really trying to build a very strong competitive position. We have the unsecured investment-grade ratings from the agencies that we got in February. That's a big head start. We've got an in-house team of 7 lawyers who have created most of the standardized documentation around the modern ground lease. So I think we've got a lot of competitive advantages in-house, but we look forward to others joining this revolution and helping more and more customers really unlock this value that's been tied up and really held hostage to this inefficiency that the corporate world got rid of 20 years ago. And we asked the question, why isn't anybody doing it for commercial real estate owners and the answer was we should go do that.

Yes. I want to come back to the ground lease -- the intricacies of your ground leases in a second. But before we do that, I actually want to talk about the value proposition of your stock. From my perspective, being a debt guy by background and by training, I can look at a ground lease, and it feels like a AAA bond proxy. I mean, unless a meteor hits New York City and then we all have bigger problems, it's a pretty stable cash flow. But the lessor actually owns the building, you own the building. And so I guess what I'm asking you in a very roundabout way is, do you think you should be getting the value for that property in addition to the stream of income. And what do you tell the person that's cynical and says, yes, not so much.

Well, it's an insightful question because I think if you come at it from the perspective you did, which is let's break it down into its components, there is a long-term ultra-high-grade ultra long-term call-protected cash flow stream. What does that look like? Well, that looks like a long-term high-grade bond. We can look in the market typically similar profile, similar maturity, similar credit, bonds are trading in the low 3s today. And we can show the contractual cash flow streams we've built in this diversified portfolio around the country that generates something north of a 5% return. And as you know, in the AAA world, if you can beat the bond benchmarks by 25 basis points, you're going to win a lot of awards at the end of the year. We've created a cash flow stream that's extremely comparable across all the major metrics. That's 100 to 200 basis points higher and fully call protected throughout. So we think that dynamic, if you can see it through that lens, you'll start to understand what got us very excited about the business. But then you'll also as a fixed income investor realize bonds only pay back your initial investment at the end, and when we look at ground leases, we make the obvious statement as you did that, hey, but at the end of the lease, you don't just own your investment bank, you get whatever is on top of your land as well. So all the appreciation from day 1 till the end of the lease term is really aggregating on your behalf. And we saw that what most people were doing is trying to analyze that on a one building basis and saying, "Well, it's way out there, and buildings grew relatively slowly, and the discount rate for a single building has idiosyncratic risk. So the discount rate is quite high. Eh, the net present value of that thing way out there discounted back at high rates is not very much." And that is sort of the gateway to unlocking the answer to your question, which is what if you could make the growth rate much higher and the discount rate much lower? And what we said is, well, we're building a business that is rapidly diversifying across the top 30 markets by geographic location, by sponsor and ultimately by product type. And so when you build a big diversified portfolio of real estate, it has a lower discount rate than a single asset. And in terms of growth, people said, well, buildings -- an individual building grows 2% to 3% kind of with inflation, maybe a little better if the sponsor is really good. And we said, well, we've actually been growing that component of value by almost triple digits for 4 years in a row, almost 100%. So it's not 2% growth anymore, the much higher number, it's not 7% or 8% discount rate, it's probably 5% or 6%. And now you do the same math and the NPV suddenly is enormous. And this is sort of the breakthrough of this is not an asset, this is an enterprise. This is not a single ground lease, this is a rapidly growing portfolio of ground leases around the country. And when you look at the 2 components of that portfolio, it's cash flow stream, it's bond like rent streams, you're going to come up with a very attractive price, $70, $80, $90 a share. And then you're going to say, well, what about the other assets? What about all that value building up on top of your land that's growing at this very high rate that's diversifying to create a much lower discount rate. Can you do the NPV on that for us? And what we've historically said is, not yet, we want to improve our growth rate, we want to prove the diversification, we want to prove the rating agencies see the stability of our company. But as we started to tick off each of those things, at the beginning of this year, we said, oh, we're ready to talk about this asset. You can actually plug in what's sitting on our land today, $5 billion to $6 billion of buildings. How fast is that pool growing? Well, it's been growing at 97% compounded 4 years in a row, but let's knock that down to something very low single digits. And what's the discount rate for a diversified pool of ownership in high-quality institutional real estate around the country, about 6% unlevered. So if we're growing faster than our discount rate, and we already know we're starting with something that's $5 billion to $6 billion on top of our land that's going to grow faster than its discount rate. You and I can do that number pretty quickly and say, look, it's $5 billion to $6 billion, and it's growing faster than this discount rate and you got 53 million shares, that looks like another $100 a share asset that nobody is paying attention to. And that's where we kind of came out 2 months ago and said, we're ready to talk about the second asset, not just the cash flow stream, the bond like AAA like quality of that. But this second asset, everything that's on top of just getting your money back. And because we're a liquid company, Richard, this is really important. You don't have to wait 99 years or 82 years or 68 years. We've made this company liquid so you can decide, are your assumptions above or below the market every day and go I want in or I went out. And this is going to be the really powerful unlocking feature because no liquidity discount, no nondiversification discount and adding external growth means the value of a business that those institutional ground leases is far more than a single ground lease. And that's the message we're going to start spreading not just the real estate investors, but anybody who's in the financial services or investment world that believes in net present value is going to find this very compelling.

Yes. So that's an amazing story. I get it. I can see my DCF analysis right now, even though you're bemoaning the fact that we don't cover your stock. So that's a discussion for another day. But I want to maybe ask a cynical question. Great for you, why does a real estate owner want to enter into a ground lease? Why bother?

Yes. So our mission is to deliver our building owners the lowest cost, longest term, most efficient capital they can access. And the pitch is really simple. It's -- if you think about what corporate CFOs have done for the last 20 years, they've realized that their operating business should be capitalized very differently than the fixed assets, the real estate assets they used to run that business. So you know better than most probably know asset light. You don't need to own the warehouses. You don't need to own the casinos. You don't need to own the cell towers. You don't need on the data centers. Because the 2 businesses are so fundamentally different. They have different risk profiles, different return profiles. Why in the world would you ask one investor in one investment to finance and capitalize these 2 extremely different assets? And so we've seen the capital markets over history be very, very clear. We like efficiency. We want to see the highest and best capital for the operating business, and we want to see the highest and best capital for the fixed asset business in the corporate world. And we went to the commercial real estate world and said, you own a building and you own land and you're going out to investors and saying, give me money at 12% or 14% or 18% on my equity, and I'll buy this building and the land. So for the land that's basically a 5% asset, you're raising money at 10% to 12% to 15% to buy a 5% asset. That's crazy. These are 99-year AAA bond like instruments, the operating business, the building is managing, leasing, marketing, designing, repositioning, buying, selling, financing. That is a double-digit return ROE business. And we're going to be a much better buyer of the land than any individual owner of a building. And so 1 plus 1 here can equal a lot more than 2. We are in the customer business, so we give a lot of that benefit right back to that customer, which gives them the lowest cost, least maturity risk, slice of capital that they can access. Cheaper than equity, cheaper than preferred, cheaper than mezz, most times cheaper than even senior capital. Eliminates the maturity risk, so they don't have to worry about paying it back. A leasehold lender doesn't have to worry about somebody coming due ahead of them. And so what we really figured out basically because we've been in the net lease business for 20 years is that opportunity to bring that efficiency to commercial real estate would enable building owners to be much more capital efficient, avoid a ton of friction costs every time they're transacting on their building, they're paying fees tied to the land, which really has nothing to do with the building, and we would reduce their maturity risk instead of taking down 65%, 70% leverage, they could cut that in half. And so that combination of attributes, higher capital efficiency, lower friction costs, lower maturity risk means they're going to generate 300 to 500 basis points higher IRRs on sort of a 10-year hold basis with a lot less risk. And in a capital market that's getting more and more competitive, can you really afford to be so inefficient to go to your investors and say, I'm going to take your 15% money and I'm going to buy 5% bonds. We don't think so. We think the capital markets will not accept it much longer. We think limited partners will not accept it. And we always end with the, is there any other place in the capital markets where you have to buy the bonds to buy the stock of a company? And the answer is, of course, not. And we say the same thing for commercial real estate, why do you have to buy the bond to buy the stock? They're 2 different businesses, they have 2 different risk/reward profiles. We will pay more for the land than it is worth to any building owner and unlock that value for them so they can reinvest in the things they do really well, make those higher returns with less risk for their customers, avoid those unnecessary friction costs, and everybody wins. And if there's a holy grail for us, it's to be in a business where everybody wins. Our customers are better off, our shareholders are better off. The customer gets to access capital he never had a chance to access before. And our shareholders get to invest in an asset class that made fortunes for about 6 people, monarchies, churches, institutions that were lucky enough to own land in a single urban market. Well, now, you, as an investor, get to own the best land in the top 30 markets in the United States. So we're bringing something that has really never existed before. But has merit for the customer and merit for the shareholders that I think is going to become more and more obvious over time.