Modern ground leases amidst COVID-19 crisis and recovery

Modern ground leases amidst COVID-19 crisis and recovery

7 min read

Safehold and iStar Chairman & CEO Jay Sugarman discusses the role ground leases can play in the wake of a worldwide pandemic

Safehold and iStar Chairman & CEO Jay Sugarman recently participated in a virtual CEO roundtable focused on ‘Leadership in Real Estate During Crisis and Recovery’ as part of the KBW 2020 Real EstateFinance Conference. The following are excerpts from KBW moderator Jade Rahmani (JR) and Sugarman (JS).

JR: Jay Sugarman, you perhaps have a unique experience, as iStar both survived the global financial crisis, but over the last several years has undertaken a dramatic shift in strategy. Could you please share your perspective on key lessons learned from prior cycles and also comment as to whether iStar’s pivot to ground leases in some ways anticipated a turn in the economic cycle?

JS: Thanks Jade, thanks for inviting me. The interesting thing about focusing on ground leases is you start to think in 100-year blocks. So it’s always a bit interesting when people ask us what our rent collections were this month. We’re thinking much more about what’s going to happen over the next 10, 20, 30, 40 years. We look through a lens that is a little bit different, and when we hear people talk about the end of New York City or the end of urban gateways — this may be one of the great opportunities if that mindset kicks in. We’ve heard that once every 10, 20 years. Everybody writes off these major financial centers as obsolete and we just don’t believe that.

When you think about the long-term arc of history, it bends towards progress. Obviously, the response to this pandemic was tragically bad — incoherent. I hope we take the lessons from all the mistakes that have been made, primarily the idea that this will be solved top down. There’s really been no engagement from the citizenry to actually help solve this problem. We feel like data will solve this problem, but it’s going to come from 330 million Americans providing data up, not government or scientists providing data down. That will be the lesson we think will be learned, and it will make us a stronger society going forward.

Certainly the technological and medical innovations we’ve seen in our lifetime give us comfort that making 100-year ground lease bets in major markets with smart real estate operators in great buildings is a great place to be. As for the strategy shift, we were smart enough to understand that the markets felt toppy to us and more commodified than we’re comfortable in, so we tried to find something new and innovative. I’d give ourselves credit for that, but we had no idea — similar to ’07-’08, when we also thought bad news was coming — we had no idea it was going to be quite this severe.

I think our goal is always to find things that make our industry better and more efficient. We think that modernizing ground leases provides one of the largest users of capital, which is real estate, with a better, more efficient tool — more capital efficiency, more cost efficiency, risk reduction. So, we hope PropTech, what we’re doing in the ground lease world, we hope what [panelist and Starwood Capital Group Chairman & CEO] Barry [Sternlicht] is doing in hotels — these are all long-term trends, they are things that for the next decade will be [marked by] progress, not regression. So we’re happy to make investments in great markets with great operators, even if there’s a monthly hiccup, quarterly hiccup, annual hiccup, two-year, four-year hiccup. I think the smart investors in this period will go back to what they learned about how this country and the real estate operators in it always find a way to find the next big thing.

Our view is that a lot of pain was unnecessarily inflicted on the world because we were unprepared. We didn’t know how to deal with it, we ignored the signs, but we’re going to learn how to be a better — hopefully, a better — country and better coordinated the next time it happens or the next time a challenge comes around. That’s a 100-year view. It’s based on going back hundreds of years and looking at how societies change, and we still believe, long-term, leadership matters. [We] didn’t get it this time but I think a lot of tough lessons have been learned and, hopefully, coming out of this, the next long arc will again be an upward one, and one of progress on a lot of fronts that maybe we never even thought about.

JR: With the long duration nature of Safehold’s capital, do you see an opportunity to make any opportunistic investments and also increase the diversification of SAFE’s portfolio, perhaps in some of these secondary markets, the growth markets like Nashville and Austin?

JS: Yeah, look, we’re in Nashville, we’re in Austin, we love those cities. We do agree there’s a shift that started long ago and continues. Again, bad leadership in some of these legacy cities will certainly hurt them. But, when the pandemic first began they started looping Escape from New York with Kurt Russell — that dystopian future of New York, I just don’t believe in. If you look at London, that’s still the epicenter of the U.K. a thousand years later, Rome is the epicenter of Italy. These great cultural cities go through many waves and if people want to sell New York at dystopian prices, yeah, we’re going to step in.

Now, it’s easy to say all this because we come in at 35 cents on the dollar, so we don’t have to worry about what’s going to happen tomorrow or next week or with this administration. Many think the current administration is creating a lot of damage, but again, in the ground lease business we’re working with our customers over long periods of time to find ways to help them generate higher returns no matter what the environment is. We just want to create a better capital solution for them, and if they can buy things even cheaper than they could before, we will help them take advantage of that.

One thing I do believe, Jade, is that real estate has some of the smartest entrepreneurs in the world who walk every corner and decide what the future is going to look like, and we want to harness that energy, that entrepreneurial spirit, wherever it is, whether it’s Austin or Nashville or the next city none of us are even thinking about. Our goal is not to get in the way of our customers, our goal is to help them maximize their ideas with the cheapest, most efficient capital possible. Whether you call that opportunistic, our view is real estate is one of the largest investment classes, it’s stockpiled with really smart, innovative people, and we have the easy job: we just have to give them the fuel to do what they do well.

I like this [ground lease] business a lot, as you can tell. I think it is a perfect spot for us to use everything we’ve learned in the finance business, the sale-leaseback business, the corporate world, the capital markets, and try to deliver all that knowledge and expertise to the people who really create the future, and that’s a fun place to be when the world is changing. We hope to be helping people like [panelist and Digital Colony CEO] Mark [Ganzi], or helping people like Barry [Sternlicht], or helping people like [panelist and Walker & Dunlop CEO] Willy [Walker] serve that next generation in a way that we know won’t be what it is today, but whatever it is, we’ll figure out how to make it a better 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.

Connect with Safehold

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Tim Doherty

Chief Investment Officer

West Coast

Steve Wylder


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