Safehold : Q1 2022 Safehold Inc Earnings Call - Edited Transcript

REFINITIV STREETEVENTS

EDITED TRANSCRIPT

Q1 2022 Safehold Inc Earnings Call

EVENT DATE/TIME: APRIL 21, 2022 / 2:00PM GMT

CORPORATE PARTICIPANTS

Brett Asnas Safehold Inc. - CFO Jason Fooks Safehold Inc. - SVP of IR

Jay S. Sugarman Safehold Inc. - CEO & Chairman Marcos Alvarado Safehold Inc. - President & CIO

CONFERENCE CALL PARTICIPANTS

Caitlin Burrows Goldman Sachs Group, Inc., Research Division - Research Analyst Derek Russell Hewett BofA Securities, Research Division - VP

Harsh Hemnani Green Street Advisors, LLC, Research Division - Associate Ki Bin Kim Truist Securities, Inc., Research Division - MD

Matthew Philip Howlett B. Riley Securities, Inc., Research Division - Senior Research Analyst Nathan Daniel Crossett Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

Richard Hill Morgan Stanley, Research Division - Head of U.S. REIT Equity & Commercial Real Estate Debt Research and Head of U.S. CMBS

Richard Charles Anderson SMBC Nikko Securities America, Inc., Research Division - Research Analyst

PRESENTATION

Operator

Good morning, and welcome to Safehold's First Quarter 2022 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 Jason Fooks, Senior Vice President of Investor Relations and Marketing. Go ahead, sir.

Jason Fooks Safehold Inc. - SVP of IR

Good morning, everyone, and 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, our Chief Financial Officer.

This morning, we plan to walk through a presentation that details our first quarter results. The presentation can be found on our website at safeholdinc.com and by clicking on the Investors link. There will be a replay of this conference call beginning at 2:30 p.m. Eastern time today and the dial-in for the replay is [phone], with the confirmation code of 9277384.

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, 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 S. Sugarman Safehold Inc. - CEO & Chairman

Thanks, Jason, and welcome to everyone joining us today. The first quarter of 2022 was a strong one for our modern ground lease business, more customers, more cities and more property types are benefiting from the more efficient capital that Safehold ground lease can provide. Earnings grew substantially. Deal flow was very strong. We crossed the $5 billion mark in terms of portfolio size, and we made important progress in accessing 30-year unsecured debt for the first time and closing our first round of CARET investors.

Despite all this positive net share price has obviously underperformed as rates have risen, and we want to spend some more time on this call giving a clear picture of what inflation means for our business and why we continue to think our business is worth quite a bit more than what we see on the screen.

One of the most important ideas embedded in Safehold's business plan is that compounding creates wealth. The higher the rate of compounding, the better. By creating a growing diversified portfolio of high-quality ground leases, we believe we can harness that equation for investors in a unique way, both in the rental income component and in the capital appreciation component of the portfolio.

Let's take a look at the rental income component. Given the principal safety and high-grade credit metrics of ground leases, the concerns expressed to us are rarely about credit risk, but generally centered on interest rate and duration risk. Of course, rising rates take a heavy toll on fixed coupon bonds, particularly long-term fixed coupon bonds. But our ground leases are different than most fixed coupon bonds.

In addition to base rents, our typical ground lease includes fixed rent bumps of approximately 2% per year on average over their life.

Further, almost all Safehold ground leases include some form of inflation protection with the majority of our ground lease structures, including a periodic upward rent adjustment in the form of cap CPI lookbacks when inflation stays above 2% for extended periods of time.

So it's important to calculate inflation adjusted yields for Safehold's portfolio when inflation kicks up, given ground lease economics are in some respects, more like tip securities than straight fixed income investments.

Our models show these potential inflation-linked increases to our rents, mitigate interest rate and duration risk and in certain cases, can actually increase the net present value multiple on the equity in our existing portfolio after taking into account in-place leverage.

Potential inflation-linked increases also create solid value multiples in new deals and make them substantially more attractive than most fixed coupon investments.

Similarly, on the capital appreciation side, compounding at higher rates is better than compounding at lower rates. Increases in replacement costs have generally led to long-term increases in value for well-located real estate in major cities. And as a result, higher inflation has generally led to higher replacement costs and higher values.

We've seen this dynamic in our research on many of the assets in our existing portfolio. So CARET, which is intended to capture the growing value of a portfolio of high-quality institutional real estate should directly benefit from higher replacement costs over the ground lease term. Of course, short-term dynamics don't always follow the long-term arc, but we are comfortable that our business is well positioned to benefit in both high and low inflation markets and that each ground lease we execute is value additive for shareholders even as rates have risen. We can talk more about these dynamics, but let's have Marcos and Brett dig into the details of the quarter first.

Marcos?

Marcos Alvarado Safehold Inc. - President & CIO

Thank you, Jay, and good morning, everyone. Let's start on Slide 3. As Jay mentioned, we are pleased with the performance during the first quarter, characterized by solid earnings results and strong investment activity. Fresh debt and equity raised during the quarter provides us with a significant amount of dry powder to fund our growing pipeline. And I'll let Brett go over the earnings results shortly.

First, let me provide an overview of our investment activity on Slide 4. During the quarter, we originated 10 new ground leases totaling $677 million, marking our best first quarter ever. For these new originations, we funded $519 million during the quarter with the remaining $158 million expected to be funded in the near term.

In addition, we funded $13 million associated with prior ground lease commitments.

Separately, we also made a new $38 million ground lease plus commitment on a multifamily asset in Brooklyn, New York, our fifth ground lease plus transaction since we introduced the program in the second quarter of last year.

The 10 new originations during the first quarter span 9 different markets and 7 new customers. The investment metrics associated with these deals are in line with our targets with a ground lease to value of 38% and rent coverage of 3.9x.

Under GAAP, these assets generate a weighted average yield of 4.8%. However, the weighted average inflation adjusted yield is 5.1%.

As Jay mentioned, we believe that our inflation look backs capture significant value for our business and are not understood by the market today. Brad will discuss this topic in more depth shortly.

As we look back at Q1, the pricing for the transactions close does not reflect the recent upward momentum in rates. The Q1 transactions were liability matched with the execution of our recent debt offering. As the rate environment has shifted, we have moved our pricing upwards, targeting floor cash yields approximately 50 to 60 basis points higher and on an inflation-adjusted basis, return on assets that are 80 basis points higher based on current long-term inflation expectations.

Taking into account our increased cost of capital, we believe that these adjusted ROAs, we are still creating significant value for our shareholders. And despite the increased cost of our product, our clients have reacted positively, and we continue to add to the pipeline.

Slide 5 provides an overview of our portfolio growth for the quarter. Originations during the first quarter has driven our aggregate portfolio to approximately $5.5 billion at the end of the quarter representing 16x growth since our IPO nearly 5 years ago.

The 10 institutional quality ground leases originated during the period include 5 multifamily, 3 office, 1 hotel and 1 life science asset. We remain focused on targeting our investments in the current country's top MSAs, and we're pleased to enter 3 new markets during the quarter.

On Slide 6, you can see the geographic breakdown of the portfolio as we continue to expand our nationwide footprint with the inclusion of Boston, Baltimore and Sacramento this quarter.

With that, let me turn it over to Brett to go through the financials. Brett?

Brett Asnas Safehold Inc. - CFO

Thank you, Marcos, and good morning, everyone. Moving on to Slide 7. Let me switch gears and discuss our financial performance. Revenues were $60.4 million for the first quarter, a 39% increase from $43.5 million in the same period last year. Net income was $24.9 million, a 47% increase from the $16.9 million we earned in the prior year period and earnings per share was $0.43, 35% above the $0.32 we earned last year.

While year-over-year performance was driven primarily by revenue growth associated with new originations. This was partially offset by $2.5 million of additional general and administrative expenses, which includes management fees from the equity raises over the last year plus a $1.25 million increase in reimbursable expenses that our managers charging.

Let me turn to our portfolio metrics on Slide 8. As of March 31, our portfolio's weighted average ground lease to value was 40% and weighted average rent coverage was 3.7x, which is up sequentially as TTM Hotel revenue at the properties is rebounding. By property type, our portfolio consists of 48%, office; 34%, multifamily; 14%, hotel; and 4%, life science. Our weighted average lease term is 92 years.

Turning to Slide 9. We detail our portfolios yield and how we're positioned in an inflationary environment. The market prices our cash flows relative to long-duration high-grade bonds. But the reality is that our portfolio has a meaningful embedded contractual income pickup from features that fixed rate bonds do not have. The current portfolio generates a cash yield of 3.3% and an annualized yield of 5.1%. These metrics assume a 0% inflationary environment for the life of our leases. That means no value to any CPI effects, CPI rent bumps annually or otherwise, fair market value resets or percentage rent.

Historically, because of the market's long-term inflation expectation has hovered at approximately 2%, the value of our CPI look backswere frequently ignored by external parties since the minimum contractual escalators in our Safehold ground leases are also structured with a comparable 2% annual fixed rent increase.

However, over the past months, we have seen a shift in the long term -- in the market's long-term inflation expectation. It's no longer 2%.

Federal Reserve Bank of St. Louis publishes data on the 30-year inflation breakeven, which according to the St. Louis Fed, represents "what market participants expect inflation to be in the next 30 years on average." This market measure of long-term inflation, which is calculated as the spread between 30-year treasuries and 30-year tips is up to 2.49%.

As long-term inflation expectations have moved higher, we think that it's important for all parties to understand the full value of the contractual inflation capture that is embedded in our portfolio. We have inflation capture of 96% of our portfolio. So with inflation moving higher it is a critical component in understanding our value.

Assuming the market's current long-term inflation expectation of 2.49%, our portfolio generates a yield of 5.7%, which primarily includes the value captured by the CPI look-backs in our Safehold ground leases.

While we think the current inflation breakeven is a fair base case, if we assume long-term inflation settles back down at a flat 2%, our portfolio generates an inflation adjusted yield of 5.4%. And if long-term inflation expectations move higher, in the 3.0% inflation scenario, our portfolio generates an inflation adjusted yield of 6.1%. As a reminder, our CPI lookbacks are generally capped at between 3% to 3.5% compounded inflation over the look-back period.

So if we apply the 2.49% inflation breakeven to our cash flow stream, our portfolio will generate a 5.7% yield. Utilizing today's benchmark century bond discount rate results in a significant increase in our cash flow value per share versus what the market seems to be assuming of no inflation capture in our portfolio. The takeaway here is that inflation is rising and discount rates move upwards so will our contractual cash flows as we are not just a simple fixed rate bond proxy.

Moving on to Slide 10, which provides an overview on our capital structure. During the quarter, we closed and funded $475 million of 30-year unsecured notes. We also raised $309 million of equity at $59 per share. At the end of the first quarter, we had $3.2 billion of debt comprised of approximately $1.5 billion of nonrecourse secured debt, $1.2 billion of unsecured notes and $272 million of our pro rata share of debt on ground leases, which we own in partnership. Our weighted average debt maturity is 24 years.

In addition, we had $235 million drawn on our unsecured revolver. Combined with cash on hand, we had $1.15 billion of liquidity at quarter end.

We are levered 1.6x on a total debt-to-book equity basis and 1.1x levered on the debt-to-equity market cap basis. The effective interest rate on our non-revolver debt is 3.7%, which is a 141-basis point spread to the 5.1% annualized yield on our portfolio. The weighted average cash interest rate on our non-revolver debt is 3.2%, a positive spread to the 3.3% current cash yield on our portfolio.

In line with my previous remarks about inflation and how it impacts our portfolio, we have added an additional disclosure on the slide which presents the inflation adjusted yield of 5.7%, assuming current long-term inflation market expectations of 2.49% because our long-term debt is all fixed rate with no inflation adjustments, our portfolio generates a 205-basis point spread over our cost of debt.

Moving to Slide 11. We provide an overview on our tariff transaction. As we've previously announced, during the first quarter, we sold and received commitments to purchase a 1.37% interest in CARET for $24 million to 6 strategic investors at a valuation of $1.75 billion. The $19 million sold during the first quarter was classified on our balance sheet as redeemable noncontrolling interest. We believe that this transaction was an important step as we seek to unlock the full value potential of our platform. We're quite pleased with the many encouraging conversations we have had within the investment community about the significant asset and its overall intrinsic value. The sale was the first of many steps, and we will continue to keep the market updated on CARET.

Lastly, on Slide 12, we present an updated -- update on estimated UCI. The estimated value of all the unrealized capital appreciation above our cost basis grew to an estimated $9.4 billion, a $1.3 billion increase or 16% since our last update last quarter and significant