Earnings Call Transcript - SAFE Q2 2020

Jason Fooks, Senior Vice President of Investor Relations and Marketing

Good morning, everyone. Thank you, Tiffany, and thank you for joining us today for Safehold's Second Quarter 2020 Earnings Call. On the call today, we have Jay Sugarman, Chairman and Chief Executive Officer; Marcos Alvarado, President and Chief Investment Officer; and Jeremy Fox-Geen, Chief Financial Officer. This morning, we plan to walk through a presentation that details our second quarter 2020 results. The presentation can be found on our website at safeholdinc.com and by clicking on the years link. There will be a replay of this conference call beginning at 1:00 p.m. Eastern Time today, and the dial-in for the replay is 866 207-1041 with a confirmation code of 7079588. 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. The risk factors that could cause these differences are detailed in our SEC reports. Safe disclaims any intent or obligation to update these forward-looking statements, except as expressly required by law. Now with that, I'd like to turn the call over to Chairman and CEO, Jay Sugarman. Jay?

Jay Sugarman, Chairman and Chief Executive Officer

Thanks, Jason, and thank all of you for joining us today. The last three months in our country have been extraordinarily challenging ones. The tragic toll of COVID on many families and many businesses continues to grow. The negative impact on our economy has been nothing short of historic. We again offer our sympathies to those affected and our thanks for those working to help overcome this challenge. We also hope the renewed focus on racial quality and equal opportunity can help set us on the right path for the future. A prosperous United States where all are respected, where all can contribute, creates the best long-term environment for us to deliver shareholders the full promise of Safehold's unique business strategy. We certainly hope for better times ahead for all of our country. In the meantime, we're pleased that Safehold's strategy continues to deliver solid returns even during this difficult period. Our combination of principal safety, strong growth prospects, and embedded value positions us to continue to expand our platform and capture value for shareholders. Our growing scale enables us to provide increasingly compelling capital to our customers. Our capital is capital efficient, cost-efficient, and risk-reducing. Our new modern form of ground leases continues to get better and should continue to offer a better alternative for many customers. That will help them access the low-cost capital they need to meet their goals and their return targets. With respect to the quarter, while transaction volume in the overall market has been significantly reduced, we remain confident we will win our fair share of deals as transaction activity picks up and continue to explore new accretive ways to deploy capital to gain market share. The strong performance of our existing portfolio, the significant dry powder at our disposal, and the low rate environment all set us up nicely to push forward once the market reopens. We’ve been fielding more calls recently as the market tries to find its bearings. While still hard to predict, we are starting to see signs that it should be a more active second half of the year. And with that, let me turn it over to Jeremy for the details of the quarter.

Jeremy Fox-Geen, Chief Financial Officer

Thank you, Jay, and good morning, everyone. I'll turn to Slide 3 in our earnings presentation, where we present an overview of the second quarter. We're pleased with the performance of our portfolio and business during this extraordinary period. As expected, we received 100% of our ground rent during the quarter, which has given us the confidence to continue raising our dividend. In addition, solid earnings and the quality of our portfolio have led to strong stock performance, keeping us the number one performing REIT year to date. Further, we were able to close several transactions this quarter in what has been a challenging environment for real estate. We remain open for business with a significant amount of dry powder that we're actively looking to deploy. Turning to Slide 4 for the quarter's results. Revenues were $37.4 million for the second quarter, up 90% from $19.7 million for the same period last year. Net income for the quarter was $12.6 million, up 111% from $5.9 million for the quarter last year. Earnings per share was $0.24, up 39% from the $0.18 for the same quarter last year. Year-to-date figures were also strong, with revenues of $77.5 million, up 87% from $41.5 million; net income of $30 million, up 75% from $17.1 million; and earnings per share of $0.60, up 19% from $0.51 reported for the same period last year. On Slide 5, we show historical dividend and stock performance. As announced, we raised our dividend by 4% to approximately $0.649 per share. This is the second consecutive year we've raised our dividend by 4% and is consistent with our current policy to grow our dividend at twice the rate of inflation. Additionally, our stock has been a strong performer this year, in part because the market has begun to recognize the value embedded in a long duration contractually growing high credit quality cash flow stream with significant principal safety. Slide 6 provides more detail on our portfolio. As we discussed last quarter, the real estate industry has significantly curtailed acquisition and disposition activity in the face of COVID-caused uncertainty. Nevertheless, we closed 4 deals this quarter, totaling $61 million. At the end of the quarter, our portfolio stood at $2.9 billion. Based on our cash at hand and capacity to draw on our revolving credit facility, we have approximately $900 million of levered purchasing power to continue our growth. On the next slide, you can see the geographic breakdown of our portfolio as we continue to diversify across the U.S. with a focus on the top 30 MSAs. Slide 8 shows our portfolio metrics. The average ground rent coverage of the assets in our portfolio was 4.0 times this quarter, down from 4.1 times at the end of last quarter, reflecting some of the emerging impacts of COVID-19 on some of our customers. Over the coming quarters, we expect this metric to further reflect the impact of the broader economic slowdown on our customers' properties. Weighted average ground lease to value was 37%. The combined property values we use for this metric are based on CBRE appraisals conducted annually based upon when we acquire a given asset. As CBRE continues to appraise additional assets in our portfolio, we expect our LTV metric to reflect the broader economic slowdown on the value of our customers' properties over the coming quarters. That being said, we take a long-term through-cycle view of our portfolio and continue to believe our portfolio is well protected through a combination of our senior position in the capital stack, diversification, and the long-term nature of our contracts, as demonstrated by our receipt of 100% of ground rent. For the quarter, annualized GAAP rent after depreciation and amortization was $155 million or a 5.5% yield. Annualized cash rent was $98 million, representing a 3.5% cash yield. Our portfolio is 62% office, 19% hotel, and 18% multifamily. Our weighted average lease term is 89 years. Turning to Slide 9. At the end of the quarter, unrealized capital appreciation stood at $5.2 billion, representing a 12 times growth since our IPO in mid-2017. Our UCA valuation process obtains appraisals on the properties in our portfolio on an annual basis with a portion being reappraised each quarter. This metric does not fully reflect the impact of COVID-19 on the value of UCA. As CBRE continues its appraisal process, we expect to see the broader economic slowdown reflected over the coming quarters. Slide 10 presents detail on our capital structure. Our equity market capitalization is $2.7 billion with $1.2 billion of book equity. We presently have $296 million of cash and revolver availability. We're conservatively leveraged at 0.6 times to equity market capitalization and 1.4 times debt-to-book equity. We have $1.7 billion of total debt. As we previously announced, we closed $106 million of long-term financing during this quarter. The weighted average interest rate of our debt is 4.0 times, which is a 150 basis point spread to the 5.5% yield of the portfolio. Our cash interest rate is 3.1 times, and our debt has a 31 years average maturity. In conclusion, Safehold had strong, steady performance in the second quarter. We're focused on continuing to execute our strategy and remain confident in the long-term vision of what we're building at Safehold. And with that, let me turn it back to Jay.

Jay Sugarman, Chairman and Chief Executive Officer

Thanks, Jeremy. I just wanted to reiterate what I said last quarter that long-lived assets financed in long-lived debt mean we are mostly focused on long-term values. While sectors, values, and interest rates will all go through cycles, good assets and good locations usually win out. Our goal for Safehold is to assemble a high-quality portfolio of ground leases in the top 30 markets and create a unique and valuable platform for investors and customers alike. As Jeremy said, we are still big believers in that vision. Operator, let's go ahead and open it up for questions.

Operator, Operator

Our first question comes from Nate Crossett with Berenberg.

Unidentified Analyst, Analyst

Just wanted to kind of dig into the investment activity. I think you mentioned there were four deals. Just wondering where they were, what were the property types, rent coverages, and then it looks like the effective yield of 5.2 was a bit below average. So I was just wondering if there was anything to note there.

Marcos Alvarado, President and Chief Investment Officer

Nate, it's Marcos. So four transactions, two in the residential space, one in the lab space, and one hospitality asset. Consistent with our strategy. I think we are excited by the fact that these are actually four transactions that were all post-COVID, so post the disruption. Our percentage of capital per value and our coverages reflect that. One of the ground leases we acquired was an existing one and has a short duration, only 44 years. Because of that, the yield is slightly lower, which pulled down the average.

Unidentified Analyst, Analyst

Okay. That's helpful. Maybe you guys could just characterize the activity you're seeing today versus a month ago? I think you mentioned that you're hoping to see an uptick towards the back half of the year. But could you maybe quantify it a bit and just tell us how the dialogue has changed in the last month or so?

Marcos Alvarado, President and Chief Investment Officer

As we've mentioned in prior quarters and on this call, we're a transaction-based business. If you survey the large brokerage houses, transaction volumes are down something like 70% in the quarter. What gives us optimism going forward is the amount of dialogue that is going on between our investments team and their clients in the brokerage community. If I go back in time, kind of April pipeline meetings in our Monday morning investment calls were somewhat slow; today, there are plenty of transactions that we're looking at. We're prescreening, we're sizing, we're quoting, and we're issuing offers. But we need the transaction markets to open up for those to ultimately become live deals that we end up closing. So I think the dialogue feels a whole lot better than it was a month ago, and we continue to remain optimistic about Q3 and Q4.

Unidentified Analyst, Analyst

Okay. That's helpful. And just lastly, how is the dialogue on office properties right now? I'm just trying to get a sense of how work from home, potentially firms leaving New York City is kind of seeping into the dialogue?

Marcos Alvarado, President and Chief Investment Officer

Yes. We try to take a very long-term view. We're believers in New York over the long term. Over the short term, there's going to be some impact on rents. We believe there will be some winners and losers in what we classify as kind of the A assets and the B assets. But at our basis of $300 to $400 a foot, we feel really, really good about the long-term prospects of owning high-quality land in various urban markets. There's certainly going to be some noise in the office sector, and we're taking that into account in our underwriting, but we will continue to quietly pursue those assets.

Operator, Operator

Our next question comes from Rich Anderson with SMBC.

Richard Anderson, Analyst

And Jay, no storms today, so hopefully, it won't get cut off this time. So you mentioned in regard to the Equivio stock has continued to perform very well this year through all this. Perhaps a risk-off mentality, given the safety of the product and all that. If the counter to that is we get past this, and people start to get more excited about the world and risk off turns into risk on. To what degree do you think that causes a headwind to you guys, given just the extraordinary level of circumstances and the bounce back that could happen if we get to a vaccine conversation or something like that?

Jay Sugarman, Chairman and Chief Executive Officer

Sure. A couple of things in your question. First and foremost, we do think there's been a lot of progress made in getting people to just do the bond math and to understand the significant discount that we had been trading at. Collecting 100% of rent and being at the very low percentage of LTV is a very strong positive in tough times. But we also spend a lot of time with investors to help them understand the qualitative and quantitative measures that are a good way to understand the value of our company. We think there’s been a lot more understanding on the part of a wider range of investors. We think that's helped significantly close the gap, although we're still trading at a pretty material discount. I think our pitch is not market-sensitive. This is better capital; it’s more efficient, risk-reducing, and eliminates friction costs. Whether we're in a frothy market or a difficult market, we think our capital should be attractive. For investors, I believe that combination of principal safety, the ability to grow a new market, and basically being the largest and only publicly traded company doing it, revolutionizing the $7 trillion industry, makes us very comfortable that for investors, this is still early innings.

Richard Anderson, Analyst

Got it. Further to that, I understand the sentiment about market conditions. So much is about the product as an alternative to fee simple. But do low rates cause you concern? It seems the Fed is going to protect a low-rate environment for some period of time. Does that make the conversation a little bit more difficult at the margin because the availability of debt mortgages is somewhat more attractive and may stay there for a period?

Jay Sugarman, Chairman and Chief Executive Officer

Good point. It cuts both ways. The 30-year is down 150 basis points since our IPO, down 100 basis points this year. That has different impacts. One, it makes the alternatives a little bit cheaper, so we have to constantly provide a better capital solution for our customers. But our cost of funds is going down. Our cost of debt has decreased, as has our flexibility. Our portfolio's ability to grow as it diversifies is becoming evident, and we think that's going to give us flexibility to compete exceptionally well with fee simple alternatives and still make the kind of returns that excite us. As I mentioned in my remarks, we're looking at many different ways to attack this market. There are opportunities when rates go up and when rates go down. We think there are very bright prospects ahead even in a low-rate environment.

Richard Anderson, Analyst

Great. Last question on the dividend and the policy to grow at twice inflation. Do you have an estimate of what your payout ratio is in common vocabulary for the REIT industry? You focus on EPS and may have a broader swath of investors outside the dedicated community because of the type of product it is, but I wonder what the cash flow number is concerning your dividend? Where is the room to continue to grow?

Jay Sugarman, Chairman and Chief Executive Officer

Yes. I think there are three simple rules that we try to follow. One is we pay a dividend that's growing at double the inflation rate. We do try to pay out all the current cash flow to meet that standard. Our payout ratio is centered around all the free cash flow. The remaining difference between our earnings and cash payouts is reinvested into the portfolio, which drives us above-market returns. This sort of compounding effect for our embedded returns creates long-term value. We do plan to pay out a nice dividend from current cash flow, while reinvesting excess returns at above-market rates.

Richard Anderson, Analyst

Okay. So basically 100% payout?

Jay Sugarman, Chairman and Chief Executive Officer

Yes.

Richard Anderson, Analyst

Consistent in terms with other REITs?

Jay Sugarman, Chairman and Chief Executive Officer

Yes. We are open and transparent about our situation. We have no capital expenditures and no unwanted expenses. Ground leases are favorable for us in that regard. Therefore, the cash we generate will be returned to shareholders.

Operator, Operator

Our next question comes from Anthony Paolone from JP Morgan.

Anthony Paolone, Analyst

Okay. I guess, first question is, it sounds like your deal pipeline is percolating a bit more. From a practical point of view, when do you think you'll actually start to see things close again and pick back up from actually putting the dollars out the door? Do you think that Q3 can actually have less volume, and maybe it takes until Q4 before Q1 starts to close? What do you think about cash out the door in the near-term?

Jay Sugarman, Chairman and Chief Executive Officer

As you've seen with us over time, it's somewhat lumpy. That's why we often don't give you guys specific guidance, especially post-COVID. It feels like Q4, Q1, where you start to see things ramp up. Historically, it takes 9 to 12 months for the private market to start to really open back up after an event. That kind of feels like the end of this year, early next year. That said, given the dialogue we're having, our cost-effective capital solution, you could see that potentially happening earlier.

Anthony Paolone, Analyst

Okay. Do you think you can do another $60 million in the third quarter? Was some of that the Q2 stuff entered pre-COVID?

Jay Sugarman, Chairman and Chief Executive Officer

No, the Q2 stuff was all post, so yes, I remain optimistic. Hopefully, we can do better than Q2.

Anthony Paolone, Analyst

Okay. That's helpful. As you're looking at the pipeline and sizing up what's happened, is there any part of the market emerging as either more interesting for you or not, whether it's property type preference or geographic preference?

Jay Sugarman, Chairman and Chief Executive Officer

I would say the multifamily space is probably the most active engagement within our pipeline. Those assets are trading. The government agencies are providing both fee and leasehold capital. Although values are down, we've seen some high-quality assets trade 5%, 6%, 7%, or 8% down from pre-COVID. So I feel good about that asset class. As I mentioned, we’re still engaged in high-quality office assets in top locations. Although there may be significant short-term or medium-term issues in that space, we believe in the long term, especially where we invest.

Anthony Paolone, Analyst

Got it. Where is the debt side on the sort of 30-year type transactions that you have done with the rate matching the terms of the underlying collateral? What is pricing today for that, both going in cash-on-cash and an effective rate basis?

Jay Sugarman, Chairman and Chief Executive Officer

I'll take that one. Our overall portfolio has been around 4%, closer to 3% in the starting rate. We're definitely seeing new deals being quoted inside that range. The last deals have been quite attractively priced to us, giving us flexibility on our pricing for customers. The market is certainly not as liquid, so we don't want to reduce it down to one or two deals and predict exactly where the market is going to shake out, but rates have definitely fallen towards the mid-3s. That implies starting rates sub-3. So that's good news for our ability to provide capital to customers at lower prices.

Anthony Paolone, Analyst

Okay. And just the last one for me, concerning the yields in the quarter, I think you mentioned 4.8 effective and then 5.2 underwritten effective. What's the one we should think about for accounting purposes? Should we think about the 4.8 and the 5.2 sounding like we might think about Goren because of the shorter duration on one of those deals?

Marcos Alvarado, President and Chief Investment Officer

4.8 is the accounting effective yield, and 5.2 is our underwritten yield. It doesn't relate to the duration; it relates to one of the ground leases that we acquired with a percentage rent cost, which were not for accounting purposes was allowed to book.

Operator, Operator

Our next question comes from Kevin Kim with SunTrust.

Kevin Kim, Analyst

Just sticking with that topic, what was the going-in cash yield for the $60 million of deals you closed? Can you hear me?

Marcos Alvarado, President and Chief Investment Officer

Give me one second. Yes. Sorry.

Jay Sugarman, Chairman and Chief Executive Officer

It was 3.5%.

Marcos Alvarado, President and Chief Investment Officer

Yes. Thank you, Jay.

Kevin Kim, Analyst

3.5%. Okay. And your weighted average rent coverage of 4x. Can you just help me understand that a little better? Does that actually reflect the trailing 12 months, including hotels, and I saw your footnotes that you mentioned? Or do you have this correction where if the asset is unstabilized or is a development asset, you can use projected stabilized NOI? Is that at all being used for hotels in this environment?

Jeremy Fox-Geen, Chief Financial Officer

Why don't I take that one? It's Jeremy, Kevin. So I think you've got it right. It's largely based upon trailing 12-month NOI as reported by our properties. The full impact of the economic slowdown over 18 months has not been reflected in this metric yet. Now, when you specifically ask about hotels and whether we use stabilized estimates, we don't—we're using reported trailing 12-month NOI as available from our properties.

Kevin Kim, Analyst

Okay. Any insights in terms of the conversations you're having with your hotel operators? Can you provide some context on the LTVs as underwritten? How comfortable do you feel that those hotels will be money good for the long term?

Jeremy Fox-Geen, Chief Financial Officer

I think from a long-term perspective, we take a 100-year view of our properties concerning the GLTV metric that we report. The properties on our land typically get appraised annually by CBRE in the quarter after acquisition. They only appraise a portion of our properties each quarter. So the full impact of the slowdown from COVID hasn't yet been reflected in this metric. I'll ask Jay or Marcos to add commentary about the conversations we're currently having with the hotel owners.

Marcos Alvarado, President and Chief Investment Officer

If you think about the pre-COVID world, the hotel kind of LTVs are consistent with our portfolio. We're taking a long-term view. Currently, there is no dialogue with any of our hotel owners. Our ground rent payment represents a fraction of the invested capital behind us. For them not to pay our rent and effectively hand us an asset for that kind of spread of almost 1,000 times rent payment versus capital invested just doesn't seem probable in this environment unless you see value destruction north of 70%. Although there's been some value destruction, we're not seeing that severe a decline by any means.

Operator, Operator

Our next question comes from Jade Rahmani with KBW.

Jade Rahmani, Analyst

I wanted to ask if you could give an update on the SAFE/STAR program. Is there any potential for opportunistic investments that this strategy could be deployed into to perhaps generate higher yields than your core strategy is targeting?

Jay Sugarman, Chairman and Chief Executive Officer

SAFE/STAR was one of the things I mentioned in terms of our programs and new ways to create accretive deal flow. It isn't so much about creating excess returns, rather it's about giving someone a one-stop capability. The last 20 or 30 years has been a key way to provide the best solution for a customer. Our goal of SAFE/STAR is to expand our market share. We believe we're getting quite a bit of interest in that program. We continue to see what I think we're up to about seven or eight deals now. It is a valuable tool in our toolbox for specific customers and should allow us to find some accretive pockets that wouldn't be available otherwise.

Jade Rahmani, Analyst

Thinking about the turmoil that's played out in the mortgage REIT and fund space—many of those lenders are highly dependent on credit facilities and repo financing that have mark-to-market provisions. iStar historically was active in the transitional property space, and I think some of the Safehold investments are on properties that have significant construction elements as examples. Are you looking to provide ground lease financing on transitional properties? Or is the core focus on existing, stabilized assets?

Marcos Alvarado, President and Chief Investment Officer

Jade, I'd say we look at everything. Some of the SAFE/STAR activity fits into our transitional bucket where capital has somewhat dried up. Our one-stop capital solution is able to offer clients solutions, whether they have a construction loan coming due or a bridge loan coming due. We’re having a fair amount of dialogue, especially in the multifamily space across these so-called transitional assets.

Jade Rahmani, Analyst

Could you quantify the value attributed to residual rights when underwriting a ground lease? Is it on an NPV basis so far into the future that it doesn't have a material impact on your underwriting? Or is there some percentage you equate historically to represent the value of those residual rights?

Jay Sugarman, Chairman and Chief Executive Officer

We always start with the cash flow stream to ensure that we think the deal is accretive right off the bat. As we've said before, as the portfolio grows, scales, and diversifies, we think we're building an asset class in the unrealized capital appreciation account that can be monetized. People will begin to understand its value as it gets bigger and more scaled. We have not incorporated that into our underwriting yet. We would like to be larger and have a bigger footprint before we factor that kind of value into our shareholders' asset equation meaningfully. For now, we're primarily focused on the cash flow component to build the business to get it to scale.

Jade Rahmani, Analyst

Based on your comments regarding CBRE's appraisal process done on an annual basis, with certain properties being assessed quarterly, if you think about the outlook for commercial real estate prices, I would anticipate values to be down 15% to 20% overall and greater than that in certain geographies or hard-hit asset classes like hospitality and retail. What do you think that implies for the value of unrealized capital appreciation? Would it decline in line with that price decline, or would it decline by more because it's residual at the tail end of this extensive time period?

Jay Sugarman, Chairman and Chief Executive Officer

The purpose of getting CBRE to conduct appraisals is to get a real-time sense of the value of the buildings on our land. The appraisal process is somewhat lagging and will phase in over four to six quarters. Appraisals themselves take a thoughtful look at values. We don't think the endgame of UCA factors into that equation; we want to know how the buildings on our land perform. We plan to report that every quarter as accurately as possible, but I look at it annually, as that’s when CBRE assesses most of the assets. We will continue to grow our portfolio and think the growth rates in UCA year-to-year will be attractive. Blips should be expected, and cyclical moments should also be anticipated, but we believe that the growth of our business is the long-term driver.

Operator, Operator

Mr. Fooks, we have no further questions.

Jason Fooks, Senior Vice President of Investor Relations and Marketing

Great. If anyone should have any additional questions on today's earnings release, please feel free to contact me directly. Tiffany, would you please give the conference call replay instructions once again?

Operator, Operator

Yes. Thank you. Ladies and gentlemen, this conference will be available for replay after 1:00 p.m. Eastern today through midnight, August 6, 2020. You may access the AT&T teleconference replay system at any time by dialing 1-866-207-1041 and entering access code 7079588. Those numbers again are 1-866-207-1041 with the access code of 7079588. That does conclude our conference for today. Thank you for your participation and using AT&T teleconference. You may now disconnect.