Modern ground lease adoption increasing as perception evolves

Modern ground lease adoption increasing as perception evolves

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Safehold was founded in 2017 for the purpose of reinventing the ground lease to make it value-enhancing for building owners. Since creating the modern ground lease, the company has grown its portfolio to nearly $4 billion in more than 30 major markets in the U.S. Safehold Chairman and CEO Jay Sugarman recently spoke to Commercial Observer about how the company is responding to an evolving ground lease landscape.

Commercial Observer: How has the ground lease market changed since Safehold pioneered the modern ground lease just over four years ago?

Jay Sugarman: The first and most important thing we did was to turn the ground lease business into a customer business. We understand what building owners need and how we can best provide them the lowest cost, longest term, most efficient capital. This type of modern ground lease capital has never been available before, and we’re seeing increasing adoption as we educate the market about its benefits. From a customer’s perspective, then, one of the biggest changes in the market is that ground leases can be customer-friendly and value-creating as part of the capital structure, in contrast to the landlord-friendly, value-destroying structures of the past.

Another thing that’s happened is multifamily has become one of the asset classes where modern ground leases are being used more and more often. In fact, our customer base right now is mostly urban office and multifamily. There was initially skepticism as to whether we could break into multifamily, particularly in gateway cities and fast-growing Southern cities. As we have established ourselves in top cities across the country — like D.C., New York, Austin, L.A., and Nashville — the perception around the applicability of this new modern ground lease has changed.

At what stages of an asset’s life cycle does Safehold engage with its customer base?

Most of our transactions occur at one of three points in time: when a property is about to be built, sold, or refinanced. We’ve recently added another component, our Ground Lease Plus program, which begins even earlier, when somebody buys land. What we’re now seeing is the ability to add value during the entire life cycle of a property. Any time a customer controls, or is in the process of controlling, a high-quality piece of land, that’s a good time to talk to Safehold.

What advantages does Safehold’s first-in-category status give the company today, and how do they translate to value for Safehold’s ground lease tenants?

We’re the only public company doing this, which means we have permanent capital for what is essentially a very long-lived business. We’re also the only investment grade platform, which gives us a cost of capital advantage that we pass on to our customers. And we’re the only national platform with 75 to 100 people working on this business every day. All of these factors enable us to take advantage of the economies of scale that are built into this business.

How would you categorize Safehold’s position in the ground lease market today?

We have, by far, the largest market share, the biggest platform and, we believe, the most credibility. That counts when you’re trying to revolutionize an industry.

What are some ways Safehold has evolved as the ground lease ecosystem has progressed?

Getting to an investment grade rating was an important milestone that has allowed us to serve our customers faster with even lower cost capital. We’ve also built a growing in-house team of industry experts, so we can share with our customers the best and latest knowledge about how ground leases can improve a capital structure.

How did the company fare over the course of the pandemic?

We’ve come through COVID with 100 percent payment on our ground leases, despite the difficult economic conditions. That was proof of the concept that ground leases are one of the safest investments you can make in the real estate world. We think that on a portfolio basis, they have the same characteristics as AAA-quality bonds, and our portfolio’s performance during this pandemic further supported that thesis.

On the growth front, COVID paused the markets for several quarters, but we had a very strong pipeline of deals develop in the post-Labor Day period last year, and our pipeline is continuing to grow rapidly.

From a shareholder perspective, we have benefitted from a combination of principal safety, a high growth rate, and significant financial performance in terms of [earnings per share] growth and value creation. While our share price has begun to catch up with some of our success, we believe there’s a massive opportunity yet to be tapped.

Talk about Safehold’s portfolio and how investors should think about modern ground leases as a new asset class.

Our typical asset is somewhere around 35 to 40 percent of the capital stack, sitting in the most senior position. We think that lines up very nicely with the AAA [commercial mortgage-backed securities] world.

In terms of financial performance, we have very strong, ultra-high-grade credit. When we compare the credit quality, the maturity of our portfolio and its returns with other investments in the market that have similar credit, quality and maturity, we’re generating significantly above-market returns. We’re building a portfolio that’s completely unique. It’s the first time investors have had a chance to invest in these ultra-high-quality land positions in the best markets. We’re still in the early innings of changing this industry, but investors are starting to take notice and we believe they will view this as an important sector to be invested in as we scale.

How does using a modern ground lease affect future liquidity for leaseholders?

This is an important issue. When we look back at the old ground leases, we saw that not only did they impair the ability to put leverage on a building, they had a material impact on the ultimate value when the owner went to sell.

Many of the old ground leases were written in such a way that the rent was uncertain and the terms under various outcomes were ambiguous. So, we stripped out all the provisions that made it hard to underwrite the future. We made sure we were sizing our ground leases at an appropriate size, pricing them at the lowest price possible, and structuring them in the clearest and simplest way.

When you do those three things, both the leasehold financing market and the future buyer market suddenly see this as very attractive capital. A properly structured, properly priced, properly sized modern ground lease not only helps you today, it allows that asset to trade efficiently in the future.

Unpredictable economic headwinds are creating challenging conditions for owners, lenders and buyers to have conviction in their valuations.

This is leading to a lack of liquidity in the capital markets, where owners are hesitant to sell at higher cap rates. Meanwhile, buyers and lenders are reluctant to execute transactions without a clearer sense of the cost of capital in the near term.

Consequently, the commercial real estate industry is at a crossroads, and building owners that have historically focused on traditional fee simple ownership are becoming increasingly open to more efficient capitalization strategies.

As a leader in the modern ground lease industry, Safehold helps asset owners maximize the efficiency of their capital stacks by providing low-cost capital — all while mitigating development and debt maturity risks and generating a strong return profile, said Tim Doherty, Safehold’s recently appointed Chief Investment Officer.

“Existing owners are facing refinancing at higher costs and potentially lower proceeds,” Doherty told Bisnow’s Studio B. “Developers are also seeing lower debt proceeds and higher pricing, and buyers are struggling to meet the bid-ask spread.”

Bisnow spoke with Doherty to learn more about what he is seeing in the market and the advantages of modern ground leases in all economic conditions.

Bisnow: How would you characterize the mindset of building owners and developers in this market?

Doherty: The volatile market has definitely made it difficult for owners, lenders and buyers to have confidence in their valuations, leading to a standstill in the capital markets. Owners don’t want to sell at higher cap rates, and buyers and lenders are not confident where the cost of capital will be in the near term to execute deals.

But we are seeing market transaction volume increase. People are picking their spots and executing where there is liquidity. They’re going after markets where the valuations have changed, but the fundamentals haven’t. Multifamily and industrial are great examples of product types that continue to have strong fundamentals.

Bisnow: Safehold pioneered the modern ground lease. How has the perception of ground leases changed since then?

Doherty: Pretty dramatically. When we started, the market’s perception was very different from what it is today. Before we created the modern ground lease, they were inconsistent, poorly conceived and overly complicated. We provided consistency and simplicity, taking into account the interests of all participants, including lenders and owners.

We’ve now executed over $6B on more than 135 deals across numerous markets and asset classes for different types of capital needs. This includes development, acquisition and recapitalization. It’s one thing to see the hypothetical concept. It’s another to actually see it working in practice and generating higher returns for owners, operators and developers.

With over seven years of track record, we have seen several round trips and refinancings of leasehold positions, which have demonstrated the liquidity of the leasehold position as well as the increased returns for our clients.

Bisnow: What are the key structural advantages of a modern ground lease relative to traditional real estate capital?

Doherty: It goes back to the cost of capital. We’re a low-cost provider, and cheaper than all other CRE capital available. Simplicity, consistency and a low cost of capital allow us to provide our customers with accretive, passive capital to drive better returns.

Leasehold owners benefit from less equity required upfront, eliminating friction costs throughout the term and significantly reducing refinancing risk.

Bisnow: What is your investment team focused on in the near term?

Doherty: In a volatile market, you’re always looking for sectors and deals that are actionable. You’re going into areas that are impacted on the value side, but not the fundamental side. Office has been hit on both, so that’s a very difficult one for people to peg down. You don’t know what your revenues are or what the valuation method is yet.

Residential, including multifamily, student housing and build-to-rent, is the biggest sector we’re focusing on right now because the fundamentals have not changed, even if certain markets might be seeing near-term deliveries.

Existing owners are facing refinancing at potentially less proceeds than they currently have outstanding. This is creating a capital need that can come in the form of fresh equity, such as cash in from the existing owner or new, high-priced preferred equity.

Alternatively, Safehold’s low-cost, highly accretive capital enables owners to create a more efficient, conservatively priced capital stack that reduces and, in some cases, eliminates the need for additional equity required while driving better returns.

Bisnow: How do Safehold ground leases impact leasehold liquidity when building owners sell their assets?

Doherty: We’ve seen 42 sales and refinancings behind our ground leases, so the proof of concept is there. In these transactions, the cap rates have been very similar to fee simple comparable transactions, both on multifamily and office assets, with a range of no spread on cap rate to about 10 to 15 basis points.

Having a track record on third-party market transactions has been a powerful part of the liquidity story for Safehold’s modern ground lease assets.

Bisnow: How should owners evaluate the option of a modern ground lease structure for their needs?

Doherty: We’re always here to help new clients understand the benefits for their assets as well as the liquidity track record we have seen produced with our existing clients.

In today’s current environment, we are seeing a lot of demand across all property types. The most active market is currently multifamily — acquisitions, development and recapitalization. The ground lease creates a lower blended cost of capital than fee simple stacks for all scenarios.

The added benefit today in the higher-rate environment is in recapitalizations. If an asset was purchased three years ago with 65% leverage, a 100-to-125-basis-point move in cap rates would make the debt now 85%, requiring a cash-in refinance on a fee simple basis of approximately 10% to 25% of the debt balance.

Alternatively, if the same property was recapitalized with a Safehold ground lease and a bank or agency first mortgage, the equity could refinance 100% of the in-place debt and, in some cases, take cash out upon recapitalization.

Overall, we’re still in the early innings of this business with tremendous growth potential for Safehold and our customers.

6 min read

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