Safehold Inc. (NYSE:SAFE) Q3 2023 Earnings Call Transcript

Safehold Inc. (NYSE:SAFE) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Good morning. And welcome to Safehold’s Third Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, today’s conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Pearse Hoffmann, Senior Vice President of Capital Markets and Investor Relations. Please go ahead, sir.

Pearse Hoffmann: Good morning, everyone. Thank you for joining us today for Safehold’s earnings call. On the call today, we have Jay Sugarman, Chairman and Chief Executive Officer, Marcos Alvarado, President and Chief Investment Officer; and Brett Asnas, Chief Financial Officer. This morning, we plan to walk through a presentation that details our third quarter 2023 results. The presentation can be found on our website at safeholdinc.com by clicking on the Investors link. There will be a replay of this conference call beginning at 2 p.m. Eastern time today. The dial-in for the replay is 877-481-4010 with a confirmation code of 49301. Before I turn the call over to Jay, I’d like to remind everyone that statements in this earnings call which are not historical facts may be forward-looking.

Our actual results may differ materially from these forward-looking statements and the risk factors that could cause these differences are detailed in our SEC reports. Safehold disclaims any intent or obligation to update these forward-looking statements and statements except as expressly required by law. Now, with that, I’d like to turn it over to Chairman and CEO, Jay Sugarman. Jay?

Jay Sugarman: Thanks, Pearse, and thank you, everyone, for joining us today. There’s no way around it. This has been a very difficult part of the interest rate cycle for us. By some measures, this has been the worst market for fixed income investments on record and long-dated cash flows are obviously some of the most impacted when rates rise. But cycles end and we believe we have been through 90%, 95% rate moves in this cycle. Higher rates also mean our in-place long-dated liabilities are more valuable and our embedded inflation kickers should be more valuable as well. And Caret remains, in our minds, a unique asset for Safehold shareholders that is deeply undervalued. So we continue to position Safehold to be a winner when the cycle finally ends and to continue to look for ways to expand the modern grand lease ecosystem, to find new ways to make real estate capital structures more efficient, more resilient and more like other parts of the modern capital markets.

With that, let’s have Marcos and Brett take you through the quarter.

Marcos Alvarado: Thank you, Jay, and good morning, everyone. Since our last earnings call, we’ve seen a number of macro and geopolitical events occur that have further increased volatility and uncertainty globally. In our market, commercial real estate investment activity remains muted, with a wide gap between buyers and sellers. Given the volatility in rates, the dearth of liquidity and the increased cost of that limited liquidity, there is great uncertainty about value. However, we remain confident that we’ve built an asset base and balance sheet that has durability and we will look to be opportunistic but disciplined in capital allocation going forward. As we navigate this choppy macro backdrop, we remain steadfast in our mission to own the grand lease ecosystem and continue to explore other sources of capital and new product initiatives to take advantage of the current environment.

Let’s begin on slide three. The company raised $152 million of new equity at a gross price of $21.40 per share in early August. MSD Partners, who has been a strong supporter and partner for the business, anchored this transaction by participating at their pro rata ownership level of approximately 8.5%, along with management, who invested approximately $1.4 million. This equity raise was not an easy decision given the headline share price relative to our views on the underlying value of the business. However, we decided that increasing liquidity in uncertain times, deleveraging the balance sheet to pay off the relatively high cost revolver debt and putting our best foot forward for a ratings upgrade would provide long-term benefits that outweigh the short-term pain of the raise.

This equity raise was viewed favorably by creditors and rating agencies, as Moody’s revised and upgraded our ratings from BAA1 to A3 in early October. We are pleased with this recognition and outcome, which we expect to help achieve long-term benefits in both cost and access to capital as we scale. At quarter end, the total portfolio was $6.4 billion, UCA was $10 billion and GLTV was 42% and rent coverage was 3.7 times. The portfolio credit metrics remained relatively unchanged from last quarter and we’re happy with how our thesis of investing in high quality assets and locations at low attachment points is unfolding as real estate reprices. On the capital front, we ended the quarter with $858 million of liquidity, which is further enhanced by the unused capacity in our joint venture, which is a valuable tool for us to pursue new investments and serve our customers while preserving capital.

Slide four provides a snapshot of our portfolio growth for the quarter. During the third quarter, we originated one new multifamily ground lease for $19 million, which was fully funded at closing. The credit metrics associated with this deal are in line with our portfolio targets, with a GLTV of 43%, rent coverage of 3.2 times and an economic yield of 7.1%. Subsequent to quarter end, we closed two multifamily ground leases for $34 million. These investments were also fully funded at closing, with a GLTV of 40%, rent coverage of 3 times and an economic yield of 7.3%. The recent rate uptick has had an impact on our pipeline. Of the six letters of intent executed last quarter, we saw two not close due to buyers and sellers not agreeing on a change in price as rates rose and another two be delayed as our customers had to raise incremental capital to close these transactions.

In the third quarter, we funded a total of $88 million, earning a blended 6.6% across three categories. The previously mentioned $19 million Q3 origination earning a 7.1% economic yield and $60 million of pre-existing ground lease commitments earning 5.8%. On these commitments, we expect this yield to increase in future quarters as older commitments originated in a lower yield environment burn off in favor of recently originated higher yielding investments and $9 million related to our 53% share of the leasehold loan fund, earning approximately 11%. Our ground lease portfolio now has 135 assets and the portfolio has grown 19 times since our IPO, while the estimated unrealized capital appreciation sitting above our ground leases has grown 23 times since our IPO.

In total, the UCA portfolio is comprised of approximately 34 million square feet of institutional quality commercial real estate, consisting of approximately 17,600 units of multifamily, 12.5 million square feet of office, over 5,000 hotel keys and 2 million square feet of life science and other property types. And with that, let me turn it over to Brett to go through the financials. Brett?

Brett Asnas: Thank you, Marcos, and good morning, everyone. Continuing on slide five, let me detail our quarterly earnings results. For the third quarter, GAAP revenue was $85.6 million, net income was negative $123.0 million and earnings per share was negative $1.81. When you back out the full impairment of goodwill we are taking this quarter, along with merger and Caret related costs, net income was positive $22.5 million and earnings per share was positive $0.33. The goodwill asset was created when we closed the merger and was recorded on our balance sheet, with the value at the end of last quarter sitting at $145.4 million. Goodwill primarily represented future savings and synergies associated with completing the merger and replacing our prior external management structure.

Goodwill assets are recorded under GAAP to be tested for impairment annually. However, we also are required on an ongoing basis to determine if there are indicators of impairment, and if so, test for impairment at such time. We determined that the precipitous and sustained decline in Safe stock price during the quarter was an indicator of impairment and that a full impairment of the asset was required. This is entirely an accounting-driven and non-cash impairment and does not speak to the value or durability of our asset base and Safehold certainly still benefits from being an internally managed company. Moving to Q3 EPS of $0.33, excluding non-recurring items. I want to highlight a few reasons for the decrease year-over-year. First, total G&A net of the star holdings management fee was approximately $2 million higher than the same period last year.

This increase was expected and something we’ve highlighted to the market. Over time, we expect our cost structure to provide meaningful operating leverage versus the previous growing and uncapped external management structure that would have had us paying higher management fees and reimbursables today versus a year ago if that contract were still in place. Separately to note, based on the previous two quarters’ results since merger closing, we are tracking to beat our net G&A targets for the year. Second, during the quarter, we terminated an option to purchase a $215 million ground lease underneath a spec office development property in the Greater Seattle area. The net effect of this transaction, which also included writing off a non-refundable option payment along with other accrued deal costs, resulted in a one-time net loss of $1.9 million.

Lastly, interest expense related to our revolver borrowings was higher due to elevated SOFR and a larger average drawn balance. Similar to many borrowers, we have felt the effect of the rapid pace of rate increases. Over the last year and a half, we have mitigated the impact by putting in place $500 million floating to fixed swaps, fixing SOFR at nearly 3%. Additionally, over that time, we purchased $400 million of long-term 30-year hedges that are currently in the money but not yet flowing through the P&L. I’ll walk through that shortly as the present rate environment continues to be an earnings headwind. On slide six, we detail our portfolio’s yields. Our ground leases have two different components of value. The first is a rent stream of compounding cash flows, which is akin to a high-grade bond with additional inflation protection on top that bonds do not provide.

And the second is the future ownership rights in the buildings at lease expiration. Let’s review the yields that we recognize in the bond-like component of the business, our cash flows. The portfolio currently earns a 3.5% cash yield and a 5.2% annualized yield, which is what we recognize for GAAP earnings. That GAAP annualized yield differs meaningfully from what we believe is a reasonable view on the economic reality of these ground leases. Any ground lease with a variable rent component, such as fair market value resets, percentage rent or CPI-based escalators, are penalized when looking at GAAP, which assumes zero go-forward economic value for those features. When looking across our ground lease investments, 17% of our ground leases are legacy of our acquired existing ground leases, which contain some form of variable rent and currently earn a 3.0% yield for GAAP purposes.

Yet by using a standard 2.0% growth or CPI assumption, we’ve underwritten those ground leases cash flows to yield 5.8%. Simply put, while GAAP recognizes a zero growth, zero inflation assumption for the entirety of our 99-year ground leases, we believe the market does not. This concept is the key piece in moving from the first box on the slide to the second. The first box is GAAP. The second box is simply an IRR calculation on our portfolio’s cash flows, assuming 2.0% CPI for any leases with a variable component. The majority of our ground leases, which have 2.0% annual fixed bumps and periodic CPI lookbacks, this 2.0% growth on economic yield scenario is the same as GAAP. However, it’s important to distinguish the 17% subset that has a component of variable rent, and when you calculate as such, you’ll arrive at a 5.7% total portfolio economic yield versus the 5.2% GAAP yield.

Moving on, the third box is a continuation from the second box. The only difference is that instead of using a base case 2.0% CPI scenario, we assume the Federal Reserve’s current long-term break-even rate of 2.34%. This not only benefits the 17% segment, but the entire portfolio, as we will pick up additional cash flow when our periodic inflation lookbacks kick in during the coming years and this results in a 5.9% yield. The second component of value in the portfolio is our future ownership rights, which is the unrealized capital appreciation we track quarterly. Caret is the subsidiary that owns UCA, with Safe shareholders owning 82% of Caret. To-date, we’ve had two investment rounds selling small interests in Caret to third parties, the last of which closed at a $2 billion valuation.

This fourth box enumerates the illustrative value and yield benefit from Safehold’s interest in Caret. When using the 5.9% inflation-adjusted yield in box three, rather than taking Safe’s basis in the ground leases as the initial cash flow or outflow in calculating the IRR, we instead offset that basis by Safe’s interest in Caret, which is worth approximately $1.6 billion or 82% of the $2 billion valuation, which produces a 7.4% Caret-adjusted yield. This is an illustrative metric intended to highlight this important element of our value proposition and remains largely unrecognized by the market today. Turning to slide seven, we show a geographic breakdown of our portfolio. The slide underscores the portfolio’s diversification by location and underlying property type.

Our top 10 markets by GBV are highlighted on the right, representing approximately 70% of the portfolio. We include key credit metrics such as rent coverage and GLTV for each of these markets, and we have additional detail at the bottom of the page separating the portfolio by region and property type. We believe that investing in well-located institutional quality ground leases in the top 30 MSAs should appreciate in value over time. Lastly, on slide eight, we provide an overview on our capital structure. At the end of the third quarter, we had approximately $4.3 billion of debt comprised of $1.5 billion of unsecured notes, $1.5 billion of non-recourse secured debt, $1 billion drawn on our unsecured revolver and $272 million of our pro rata share of debt on ground leases which we own in joint ventures.

Our weighted average debt maturity is approximately 22.5 years and we have no corporate maturities due until 2026, which is our revolving credit facility. At quarter end, we had approximately $858 million of facility availability. I want to spend a moment on the revolver and detail the fixed versus floating dynamic and the hedges we have put in place to mitigate interest rate risk. Of the approximately $1 billion revolver balance outstanding, $500 million is swapped to fixed so far at 3%. This is a five-year swap that we executed in early Q2 of this year. We received swap payments on a current cash basis each month and at current rates produces cash interest savings of approximately $3 million per quarter that is currently flowing through the P&L.

Of the remaining 500 million drawn, we have $400 million of long-term treasury locks at a weighted average rate of approximately 3.4%. At current rates, these are approximately $75 million in the money. These hedges are mark-to-market, so no cash changes hands each month and while we do recognize these gains on our balance sheet in OCI, they are not yet recognized in the P&L. While these hedges protect us through next year, they can be unwound for cash at any point. As we look to term out revolver borrowings with long-term debt, we would unwind the hedges and attach the gain to the debt, lowering the effective economic rate we pay. The remaining unhedged exposure is largely offset by our higher yielding investments connected with the merger, including the floating rate income we receive on our leasehold loan fund interest.

The weighted average credit spread we earn on those loans exceed what we pay on our line by 392 basis points. We are levered 1.8 times on a total debt-to-book equity basis. The effective interest rate on permanent debt is 3.8%, which is 136 basis points spread to the 5.2% GAAP annualized yield on our portfolio. The portfolio’s cash interest rate on permanent debt is 3.3%, which is a 16 basis point spread to the 3.5% annualized cash yield. Lastly, as Marcos mentioned earlier, after quarter end, Safehold received a credit ratings upgrade from Moody’s to A3 with a stable outlook. Moody’s upgrade, which was issued at a time of overall market uncertainty, highlights the inherent credit strengths of the assets, capital structure and business we’ve built, and we expect this upgrade to be a long-term benefit for the company.

In the immediate, we’ve already seen a 12.5-basis-point decrease in our revolver costs based on the rating. We also remain engaged with Fitch, who put us on positive outlook in the beginning of 2023, several months after Moody’s had done so. We believe we’ve addressed a number of their key criteria and targets, and we’ll continue to maintain an active dialogue with their team with the goal of gaining momentum to drive down our cost of capital. So to conclude, while the market backdrop remains challenged, our asset performance remains strong, we have ample liquidity and capital access and we have no near-term maturities. As we continue to push on improving our cost of capital, we’ll be patient but opportunistic around new investments and look to continue to expand on our market-leading position.

And with that, let me turn it back to Jay.

Jay Sugarman: Thanks, Brett. There was a lot of noise this year with the merger, the macro backdrop and things like goodwill, and with capital market spreads moving faster than cap rates in the real estate transaction market, it’s been hard to generate the spreads we look for despite currently attractive asset economics that offer plus or minus 100 basis points over the benchmark, plus inflation kickers, plus UCA and its potential Caret value. While this side of the interest cycle has been rough, we are preparing for the other side of the cycle. PIC [ph] rates seem near and once sentiment changes, we believe our existing portfolio will be seen in a new light, and the capital market should be in a better position to help us take advantage of the attractive asset economics in the ground lease market. And with that, Operator, let’s go ahead and open it up for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Your first question is coming from Nate Crossett with BNP Paribas. Please pose your question. Your line is live.

Nate Crossett: Hey. Good morning, guys. I was wondering if you could talk about just the deal flow pipeline heading into the year. Are there any deals that are currently under LOI right now? And then just maybe on what you’re seeing, like if rates do stabilize in the near-term, like do you foresee things opening up quickly or is there more of an adjustment period? Just some color there on the pipeline would be helpful.

Jay Sugarman: Hey, Nate. So I think if you go back to the end of the second quarter, which feels like an eternity, but it’s not really that long ago. The 10-year was at 3.8 a bit and today it’s almost 100 basis points wider. I think it’s paralyzed the overall market, including our customers. So while we saw some traction sort of at the end of Q2 and the early months of the summer, we’ve seen that sort of heat off over the last handful of months. So I think we have a few things in the pipeline that are progressing towards closing. I’ll tell you that we have a little bit less confidence than we have had in the past and I sort of referenced that in my remark. We had a handful of transactions that got to the closing table with docs done and fell apart.

So I think Q4 is going to continue to remain spotty. I think the psychology that you’re sort of describing about when do people capitulate, I think it takes time. If you think about these sort of rate movements, what’s the impact on asset values? Are people willing to give up? Are you going to see distress? And as far as we can tell, that appears to be going very, very slow in today’s environment.

Nate Crossett: Okay. I think you mentioned new product initiatives in the prepared remarks. Is there anything to note there? Is there any new type of product that you’ve been doing or contemplating? Just wanted to make sure I heard that right.

Jay Sugarman: Yeah. We’re always in the lab trying to brainstorm and think through different applications of the product and so nothing that is far enough along to talk about yet, but we’re excited about some potential things in the future.

Nate Crossett: Okay. Thanks. Maybe — and then just one for Brett, just on the upgrade on the credit rating. I’m just curious how much that would hypothetically save you on debt costs versus where it was before the rating upgrade?

Brett Asnas: So we are — right now we have a split rating with Moody’s and Fitch. We’ve seen some benefit in our spreads, but I think the majority of that benefit will come when we have a second A rating. What we’ve typically seen across many borrowers in the A rating category versus BBB, most of them trade at a 30-basis-point to 50-basis-point differential. And some of the debt capital providers that we have regular dialogue with have indicated as such as well. When you start to really think about their ability to tap different pockets to deploy capital for A or better. When you think about the capital charges that they need to take, the exposures that they’re limited or allowed to take as well, those should all be benefits to us. So we’re hoping that we can continue to prove and build that track record as we’ve done over the last year to get to that second A rating so we can get that benefit.

Nate Crossett: Okay. I’ll leave it there. Thank you.

Operator: Your next question is coming from Anthony Paolone with JPMorgan. Please pose your question. Your line is live.

Anthony Paolone: Great. Thanks. Good morning. I guess historically it seemed like your value proposition to sponsors was the combination of ground lease and leasehold debt would get them more proceeds and also at very attractive rates. Can you — what is — what do you think the real pitch is right now at higher rates that you’re delivering to prospective sponsors when you’re pitching ground lease structures?