Behind Safehold’s pay dirt plan

Safehold’s first big bet on New York City dirt flew under the radar at first.

In late August, the iStar-managed real estate investment trust closed on its first deal in the five boroughs when it acquired the land under the landmarked Banknote Building, a 405,000-square-foot office building in the Bronx’s Hunts Point neighborhood, for $65 million.

And as the only publicly traded firm to focus on ground leases — at a time when such deals evoke recent troubles at Manhattan’s iconic Lever House and Chrysler Building — the company helmed by Jay Sugarman is looking to go all in.

Until recently, many observers viewed Safehold as a firm with an intriguing proposition but an unproven track record.

“I think there was a general sense that O.K., these guys are small to begin with, and they’re focused on a niche that no one has ever focused on specifically before,” said Haendel St. Juste, a senior REIT analyst at Mizuho Securities. “So there are questions about how you value [the company].”

But things quickly picked up for Safehold in the second half of last year.

In the fourth quarter alone, the REIT closed on five Manhattan land deals totaling more than $1.3 billion. Those acquisitions include existing and newly created ground leases under trophy properties and high-profile new developments such as L&L Holding Company’s $1 billion office development at 425 Park Avenue.

Safehold’s investment activity around the country totaled $1.8 billion in 2019, while New York’s share of the firm’s portfolio ballooned from zero at the start of last year to nearly half at the end.

And after hovering under $20 a share in its first year and a half, when the company was known as “Safety, Income & Growth,” it saw its stock price skyrocket last year, posting returns of 118 percent — the strongest of any REIT.

Safehold was trading above $55 a share as of late February 2020.

By fusing the arcane world of ground leases with more standardized terms and Wall Street’s fundraising potential, Sugarman and his team believe they have created something that could revolutionize the commercial real estate industry nationwide, a market the firm values at more than $7 trillion.

“Markets are relentlessly trying to get more efficient, trying to carve up investments into different risk tranches,” iStar and Safehold’s chairman and CEO told The Real Deal in a phone interview last month. “That’s something we’ve been doing in the finance world since 1990 and in the net lease world since 2000.”

Land mines

Pricy ground leases in the Big Apple have become a red flag for some real estate investors in recent years, thanks to several high-profile losses.

Last spring, the Abu Dhabi Investment Council and Tishman Speyer took an eye-popping 80 percent discount on their $151 million sale of the Chrysler Building to Aby Rosen’s RFR Realty — largely due to huge rent hikes on the building’s ground lease with the Cooper Union school.

And just a few years prior, Rosen’s firm got the short end of the stick at the landmarked Lever House, due to a rent reset dispute with the Korein family, which owns the land under the office building. RFR defaulted on a $110 million loan on the property in 2015, and Brookfield Properties and Waterman Interests have since inserted themselves to take over the property.

When traditional ground lease deals go sour, so-called fair market value rent resets are usually to blame, according to several sources. And the uncertainty around what’s considered “fair market,” in many cases, leads to a lose-lose situation for the ground lease owner and the lessee.

“People who write these ground leases will try to come up with very sophisticated definitions of value — it’s got to include this, not that,” said real estate attorney Joshua Stein, who has worked on several ground-lease cases and noted that fair-market resets can often wind up in litigation or arbitration. “This is a minefield, and it often creates tremendous disputes with very high stakes.”

But the preferred approach for determining rents in modern ground lease deals, adopted by Safehold and others, is to have fixed annual rent increases combined with periodic inflation adjustments based on the Consumer Price Index, helping to minimize ambiguity and uncertainty.

“The tenants all want the same thing these days, and the families [who own the land] are realizing that, if they want to do a deal, they’ll have to agree to these sorts of caps,” Stein said.

The few exceptions occur when landowners happen to be in possession of real estate that presents a unique development opportunity — a situation that the Kaufman Organization has become familiar with in recent years.

Kaufman has done eight ground lease deals over the past five years, more than any other developer in the city, according to Michael Kazmierski, the firm’s head of acquisitions. Many of the landowners are multigenerational families, he said, which have different needs from an institutional ground lease owner like Safehold.

“We enter into ground leases where we have an opportunity to effectively acquire great real estate in an alternative structure,” Kazmierski said. “We just want to do what we’re best at, which is operate, renovate and develop to the best of our capability.”

Several insiders noted that ground lease deals can carry specific peculiarities that can have a big impact on the terms of deals, ranging from unusual development rights to rent regulation.

Kazmierski cited situations where families may own just a few properties with little interest in day-to-day operations as younger generations take over.

“If you have one little weird thing in the property, that often ripples into a whole lot of other things in the ground lease, so each one is its own little world,” Stein said. “Even if you start with a really good template … it’s extraordinary how much each deal differs from the last.”

But Sugarman and his team of 155 people at iStar, which provide all services for Safehold, have a plan to try to codify that.

From left: The Bank Note; 425 Park Avenue; 685 Third Avenue

“We’ve made a lot of important progress in 2019, taking Safehold from just a theory to a tangible growing business,” the ground lease REIT’s president and chief investment officer, Marcos Alvarado, said on its fourth-quarter earnings call in February.

From the ground up

The concept of leasing land rather than buying it outright has existed for hundreds, if not thousands of years, sources said.

Traditionally, such arrangements had been set up by monarchs and churches — and later institutions and wealthy families — as a way to maintain control of land while allowing others to build over it.

But within the past decade, a different way of thinking about ground leases has emerged: treating them as another slice of a property’s capital stack. Sugarman pointed to the division of commercial mortgage-backed securities into differently rated tranches as another example of this.

“Over and over again in the capital markets,” he said, “people have figured out that, if you separate investments that have very different risk-reward dynamics and let investors that are most comfortable with those value them, oftentimes the sum of the parts is greater than the whole.”

Dean Britton of the advisory firm AIA Terra Partners — which specializes in dividing properties into the “leased fee estate” of the ground and the “leasehold estate” of the building on top — said, “Under any piece of real estate, you basically have a bond.”

Owning a building without the land can also present tax advantages because land rarely depreciates, said David Eyzenberg, whose eponymous firm, Eyzenberg and Company, specializes in negotiating debt, equity and ground lease deals on behalf of investors.

But the ground lease business still faces some barriers to widespread acceptance.

“Number one is psychological: ‘What do you mean I don’t own the land?’” Eyzenberg said. “Number two is that leasehold financing can be challenging.”

Eyzenberg’s firm has worked with Safehold on several transactions, including the REIT’s first deal in the Orlando, Fla., market — a ground lease under a 212-unit garden-style multifamily community known as Promenade Crossing.

Sugarman pointed out that REITs for cell towers and warehouses have helped phone service providers and logistics firms become more “asset-light,” while companies across several industries have been selling and leasing back their real estate assets. Now it’s time for building owners to take similar steps, he said.

As a public company, though, Safehold doesn’t just have to win over property owners: It also needs to convince a much broader audience of potential stock investors. And for those looking for comparables on Wall Street, Safefold’s novel business model can present a challenge.

“It’s kind of tough to value this company,” said Zachary Silverberg, an equity research assistant at Mizuho. “It still remains to be seen whether the valuation is correct or not.”

But Anthony Paolone, a REIT analyst at JPMorgan, said it’s clear that Safehold’s “deal activity really picked up, especially with some big transactions in New York City and elsewhere” last year. He cited low U.S. interest rates and the REIT’s ability to secure “unique and attractive financing” as additional positives for the firm’s stock.

A fresh start

Safehold’s mission represents a big turnaround for Sugarman, 57, who had considered retiring 15 years ago.

“I got very close to making that decision, and then the world changed,” he told TRD last year, referring to his firm’s struggles during the financial crisis, which led him to forfeit 2 million restricted shares in iStar that weren’t performing well.

Those experiences led him to rethink real estate finance from the ground up. About four years ago, iStar told investors that they were going to find the “next big thing.” And after two years of research, Sugarman had his eureka moment.

“When I look back on it and I think about it, it’s kind of obvious,” Sugarman said. “We’ve been doing this for corporations for the last few decades, trying to make their capital structures more efficient, separating the high-return operating business from the low, passive return real estate asset.”

When Safehold first went public (under its previous name) in June 2017, the firm’s $339 million portfolio was a mixed bag of interests that iStar had begun acquiring in the late ‘90s.

The initial portfolio included iStar’s fee interests in seven hotels, three office buildings, a multifamily property and a self-storage property across 10 states including California, Washington, Utah and Texas, according to a report from Kroll Bond Rating Agency in 2017. That year, iStar secured $227 million in CMBS financing for the properties in anticipation of Safehold’s IPO.

Those assets were a far cry from the more modernized ground leases that would become the REIT’s bread and butter later on.

In the case of one hotel in Seattle, the company only owns a quarter of the land while leasing the remainder from a third party. And five of the hotels in the portfolio are subject to a master lease where rent is calculated on a portfolio-wide basis. Safehold still owns these interests and highlights them as risk factors in its disclosures to the U.S. Securities and Exchange Commission.

Soon after going public, Safehold made its first acquisitions by picking up the ground under a pair of mixed-use properties on Hollywood Boulevard in Los Angeles for $142 million — and the “revolution” was underway.

“I’m often asked why no one had done this sooner if it’s such a great idea that creates all of these efficiencies,” Sugarman said. “Frankly, you needed someone who was willing to stomach $100 million of startup costs and was willing to try to change literally everybody’s minds.”

Growth spurts

For a Manhattan-based real estate firm — with a stated goal of having a presence in the country’s top 30 markets — doing big deals in the Big Apple was always a key step.

But it took a while to get there.

“It was a hard market to change some of the mindset in, and we frankly had more traction in Washington, D.C., [at the outset],” Sugarman said. “Then, we did a deal across the river in Jersey City, and then we did a deal in the Bronx. We were able to start pointing them out to people and saying, ‘Here’s the economic outcome.’”

Sugarman had come close to his first big New York ground lease deal a year earlier. In May 2018, iStar was reported to be in contract to acquire the fee interest at SL Green’s 635 Madison Avenue for $151 million — which included fair-market value resets and had about 40 years left on its term. The deal was meant to be a test case for Safehold’s model of acquiring and modernizing existing ground leases.

But in the end, Robert Lapidus’ L&L exercised a right of first refusal to acquire the dirt instead.

“In that case, I think some people saw the [remaining time] on the lease and decided they’d like to actually own the building once it expires,” Sugarman said. “That’s okay, and we’ve gone on to do several more deals with L&L.”

L&L was the building owner on Safehold’s first two Manhattan deals, including the ground lease under 425 Park — the first new office tower on the avenue in 50 years — which the REIT acquired from Nuveen for $620 million. An unnamed sovereign wealth fund was brought into the deal with Safehold retaining a 55 percent stake.

Safehold also created a new $275 million ground lease under 195 Broadway in the Financial District, as part of a deal which saw L&L and a group of South Korean partners acquire the building from JPMorgan’s asset management arm.

L&L declined to comment for this story.

The REIT also broke into several other U.S. cities, like, in 2019, Honolulu; Austin, Texas; Tampa, Fla.; and Philadelphia. It’s still on the hunt for its first deal in Boston, among other major real estate markets.

“The good thing about the customers that we’re doing transactions with in New York City is that they’re global or national fund managers, and so we expect to travel with them into other markets in 2020,” Alvarado said on Safehold’s latest earnings call.

The next pitch

Sugarman took things a few steps further and said his firm has started to pose the question, What if the ground lease, with its fixed income stream, could be separated from the ground and future rights to the building?

He acknowledged that most individual buildings would lose most of their value at the end of a 99-year leasehold but said the outlook changes when a ground lease portfolio “gets bigger and starts to scale.”

Sugarman said he thinks Safehold would need to amass around $10 billion worth of future building rights — about twice the size of what it currently has — for the proposition to make sense economically.

In anticipation of this move, Safehold has created so-called CARET (capital appreciation real estate trust) units, which entitle equity investors to a share of the profits when a ground lease is sold or refinanced. Up to 15 percent of the units are available to iStar management and employees as part of an incentive plan, while the remainder could be sold to third parties in the future, according to SEC filings.

But that part of the plan is still not ready for prime time, according to Sugarman.

“We’re not talking about it yet because we only really have one shot to get everybody to believe in this,” he said, declining to provide specifics of how the firm plans to introduce the concept to investors. “A lot of people are still skeptical, which is fine, but I don’t want people shooting at us before we’re even ready to talk about it.”

For the time being, some stock analysts are left scratching their heads. “Right now CARETs have no value,” Mizuho’s Silverberg argued. “They’re a little complicated and unique, which seems to be why there’s some question marks around the plan.”

Other players in the modern ground lease space, meanwhile, are looking to carve out their own niches. Eyzenberg, for his part, said he’s happy to continue pursuing the most advantageous ground lease deals away from the public markets.

“We’ve thought about what the right vehicle to own ground leases in is, and I don’t know if a public [company] is the best,” he said. “Because the reality is that, when the market prices your valuation every single day, I think it potentially adds volatility into an asset class that shouldn’t have volatility. So, we really prefer private ownership.”