Safehold: As Safe As Houses With A 2.7% Dividend (NYSE:SAFE)

Aerial panorama of New York City skyscrapers at dusk

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There is an old saying, “Invest into land because more isn’t getting made.” Traditional real estate investments involve purchasing both the land and the building on top. However, Safehold Inc. (NYSE:SAFE), a real estate investment trust (“REIT”), has flipped this on its head by specializing in buying up the land under buildings. Ground leases offer a safe investment for investors, as even if a building was to burn down or suffered a 9/11-style disaster, the land underneath would still be there.

Safehold’s stock price has been butchered by ~72% from its all-time highs in August 2021, despite the company growing both its top and bottom line. Thus, in this post I’m going to break down the company’s business model, financials, and valuation, so let’s dive in.

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Data by YCharts

Business Model

When people buy commercial real estate, they tend to buy the building and the land underneath it. However, these are two very different types of investments. The building on top, let’s say a major skyscraper, is the higher-returning operating part of the business. Whereas, the land underneath is a lower-returning type of investment and acts more like a bond. Safehold buys up the ground leases of commercial buildings in order to give the developers a capital boost. The company was founded in October 2016, and today has close to $6 billion in assets with over 125 ground leases across the US.

Safehold by region

Safehold by region (Q2 Earnings Report)

Safehold targets real estate across various categories from Office, Multifamily, Hotels, Retail, Industrial, student accommodation, and senior housing. Its average transaction size is between $15 million and a staggering $500 million. With an average return of between 3.25% and 4% for its leases.

The company has recently announced a merger with iStar Inc. (STAR), another REIT, which also specializes in Ground leases. This combination is expected to benefit from economies of scale, with $3 million in cost savings in year one and over $25 million by 2026. ISTAR will be able to pay off its third-party debt and move its nonground lease assets to a separate public company called SpinCO (which will then be owned by Safehold).

The merger is expected to close between the fourth quarter of 2022 and the first quarter of 2023.

Safehold cost savings

Safehold cost savings (investor relations)

Growing Financials

Safehold generated revenue of $64.9 million in the second quarter of 2022, which increased by a rapid 47% year over year. The company originated seven new ground leases in the second quarter with a value of $338 million. These new ground leases cover five property types and four different markets, which is a testament to the adoption and popularity of the service. Safehold generated solid net Income of $22.7 million which increased by a rapid 54% year over year. In addition, Earnings Per Share increased to $0.37 up 32% year over year. In September, the company announced the sale of a ground lease for a staggering $136 million, which is expected to book a net gain of $46 million in the third quarter of 2022, which is fantastic.

Q2 Earnings

Safehold (Q2 Earnings)

The company has benefited from a contractual pricing increases that have been driven by interest rates and inflation-adjusted yields. For example, if inflation falls back down to the fed’s target of 2%, then the company generates a 5.5% inflation-adjusted yield. Whereas if inflation stays slightly higher at 3% longer term, that equates to a 6.1% inflation-adjusted yield which is fantastic. The company conservatively makes its investments under a “Zero percent inflation” scenario which helps to ensure prudent returns no matter what the economic outlook.

Moving forward, the company plans to simplify its corporate structure to enable better access by from the market, for its debt and equity. The business has $3.6 billion in debt with a weighted average of 24 years. Safehold plans to secure a 30-year finance deal via its “Stairstep coupon” that better matches the cash flow profile of the business, which is stable.

Debt profile

Debt profile (Q2 Earnings Report)

The company’s $445 million in unsecured revolver debt is vulnerable to interest rate hikes. For example, in 2021 the company was paying $4.9 million in interest. Whereas, during a high-interest rate scenario (4% LIBOR rate) which looks possible based on estimates, then by 2023 the company would have to pay an eye-watering $22.5 million in interest.

The good news is total liquidity including cash on hand was $930 million, which equates to a 1.8x total debt to book equity, which is solid. The merger with iStar is also forecasted to further improve the debt profile of the business and result in a ratings upgrade longer term. The company currently has a Baa1 rating by Moody’s and a BBB+ rating by Fitch. A better rating longer term should equate to a lower cost of debt and thus a greater profitability profile.

Ratings upgrade

Ratings upgrade (Merger Presentation)

The board has approved a 4.12% dividend increase to $0.708 per share, which is great to see. The Seeking Alpha Dividend calculator highlighted a 2.74% forward dividend yield. I personally believe the business dividend is extremely stable, as ground leases rarely have unforeseen costs and have a stable cash flow profile. For example, a large building may require a major roof repair or other expensive maintenance costs which could eat into returns.

Safehold’s Valuation?

Valuing Safehold is pretty challenging, as its complex real estate structure pre and post-merger is uncertain. However, we do know the business trades at a Price to Earnings Ratio = 16.3 which is 33.3% cheaper than the real estate sector average, despite the earnings being more stable than most traditional real estate investments. Its forward Price to Funds from Operations is 14.92 which is close to 16% higher than the Real Estate industry average.

Given Safehold and iStar are the only publicly traded REIT’s specializing in ground leases it makes sense to compare these two (pre-merger) as opposed to a random REIT. As iStar trades at a cheaper P/E ratio = 1.2, that could also be an interesting method of investing in Safehold as they both will merge together.

Chart
Data by YCharts

As an extra data point, the share price relative to Adjusted Operating Earnings is expected to have a ~30% upside by 2024. In addition, Mizuho analyst Haendel Juste, has recently upgraded the stock to a “BUY” due to positive merger tailwinds and synergies.

Safehold

Safehold (FAST Graphs REITs)

Risks

Interest Rates and Floating Debt

The Real Estate industry has been built on debt, but there are two types, “good” debt and “bad” debt. Good Debt helps a real estate owner leverage control over a larger asset. However, when interest rates rise, “bad debt” can eat away at returns. I discussed Safehold’s $445 million in unsecured revolver debt previously which could be an issue in 2023. However, the company does have a strong liquidity position and is reorganizing its debt profile which may offset issues with this longer term.

Final Thoughts

Safehold is reinventing real estate by buying up-the-ground leases from various commercial buildings. The company is well-diversified across industries and sectors. In addition, the recent merger with iStar looks to offer strong cost synergies and improve efficiencies overall. Safehold stock looks to be undervalued at the time of writing and thus could be a great investment long term.

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