wo years ago I had the pleasure of sitting down with Ian Selig, CIO of Safehold Inc. ($SAFE), a groundbreaking (pun intended) REIT spun out of iStar's core business. His was, in fact, the first ground-lease REIT to go public. And despite being a core part of the real estate industry, very few public investors are aware of this side of the business.
Think of buying real estate as two separate investments. Investment one is the building, a high return asset that requires management, operational oversight, and leasing to improve revenues and resell at a later date. At the same time, the buyer is making an investment in the land, which has very long-term, bond-like returns.
A ground lease separates the ownership of the land from the building and gives the building owner the economic rights to the building for 99 years. Structurally a ground lease is very similar to any other sort of lease. The tenant makes monthly rent payments for a fixed period. The leases are net leases, which means that tenants assume responsibility for taxes, insurance, and expenditures for the duration of the lease.
Past ground leases were not put in place to enhance the value of the property owner on top of it. They were put in place for some less natural reason.
Downtown London was owned by the monarchy; churches have done similar things in New York, and Cooper Union owns the land under the Chrysler Building. But most ground lease holders are owners of land rather than efficient providers of capital.
Ground leases are inherently safe because of their position at the bottom of the “capital stack”, or the order of priority of debt and other investments on an asset, and their near zero chance of default. This gives Safehold a first claim on recoveries in the event of bankruptcy. Lease fees are naturally adjusted for inflation, and often include escalations based on the fair market value of the building on top.
The market for Ground Leases is huge. Land values are approximately ⅓ of the overall real estate market, valued at $20T. If ground-lease operators can capitalize 10 to 15% of that market, there's $2T to $3T of value spread out among a few operators. And in our view, $SAFE is poised to take advantage.
Safeholds NAV has tripled since inception four years ago but shares have rocketed and trimmed back 42% of their value YTD. We remain bullish on Safehold for several reasons. $SAFE has an appealing mix of new and repeat businesses, implying there's a massive, untapped market, and many of the customers are very happy, because close to 40% of customers have closed multiple deals with the company.
SAFE also offers a ground leasing platform called “Caret". SAFE already sold a 1.37% stake in the platform for $24MM, valuing it at $1.75B. SAFE also recently released 2Q22 earnings, where the growth continued mostly according to forecasts. The company delivered 47% quarterly revenue growth, over $380M in originations, which turns the company's post-IPO growth track record up to 17x.
In basic terms, SAFE is more than capable of covering it’s dividend in 2022 and 2023, and the growth is staggering. At a nearly 42% haircut, the business looks even more attractive. iStar and Safe recently announced a merger of sorts. iStar will spin its legacy assets into a publicly listed REIT externally managed by SAFE, move all remaining non-ground-lease assets and $400MM of SAFE stock into the spinoff and, sell 5.4MM shares of STAR’s SAFE stock to MSD Partners for $200 million. MSD is Michael Dell’s (Dell Corporation) family office. His involvement is bullish given the office's affinity for successful deep value plays.
At this valuation, the market is completely ignoring the recent merger of iStar with Safehold, and the value of “Caret” becoming publicly traded. A 60% upside through 2024 is conservative.