HOW SAFEHOLD REINVENTED THE GROUND LEASE TO ADD VALUE FOR BUILDING OWNERS
Jay Sugarman had spent more than 20 years using sale-leasebacks to provide more efficient capital to corporations when he realized he could do the same for commercial real estate owners. Here, in a Q&A interview, Safehold’s Chairman & CEO discusses how the company’s modern ground lease model solves a major inefficiency inherent in real estate ownership.
Safehold was founded because the general approach to real estate ownership was inefficient. Talk about how the initial idea for Safehold and the company's approach to ground leases came about.
Jay Sugarman (JS): At iStar, which is the external manager and largest shareholder of Safehold, we’ve been working with companies to do sale-leasebacks of their real estate for over two decades. And the thinking behind that for CFOs in the corporate world is the realization that combining a high-return core operating business and a low-return passive piece of real estate is inefficient. Those are two different investments that should be owned by two different investors. The idea of separating those two different investments and creating more efficient capital structures for corporations had a pretty direct analogy in the real estate world.
You explain why archaic ground leases are value-destroying – what are the benefits of Safehold™ ground leases that make them value-enhancing?
JS: First is capital efficiency. Untethering a high-return core operating business from a low-return passive real estate component is a tried and true way to be more capital efficient in the corporate world, and it’s the same in real estate. By capital efficiency, we mean that you can earn higher returns on the skill sets and capital deployed.
The second piece is cost efficiency. Using a ground lease can effectively eliminate a lifetime of unnecessary costs. With a Safehold™ ground lease in place, customers eliminate sizable financing fees, transfer fees and mortgage recording fees, as those costs are no longer applicable to the land component, representing approximately a third of the capital structure.
The third component is risk-reduction. Ground leases materially reduce one of the primary risks real estate owners face, which is maturity on a large amount of debt. Historically, that’s one of the most problematic moments for a building owner. A large maturity during a weak economic environment creates most of the credit problems in real estate.
What does separating the land from the building equate to as far as cost savings?
JS: If a building sells for $100 million and we come in and execute a $35 million ground lease, the building becomes a $65 million investment. If you sell that building five years later for $75 million, you’ll pay all the transaction costs on the value of the building, but not on the value of the land. If you hold a property for around 10 years but don’t separate the land from the building, and the next owner does the same and so on, that land will trade along with the building 10 times, and you’ll get hit with those unnecessary fees 10 times.
By separating the land from the building, you've effectively taken a third of the capital structure that's going to get hit 5, 10, 20 times with fees in the future and eliminated that lifetime of inefficient, unnecessary costs.
You noted that Safehold’s ground leases reduce maturity risk. Can you elaborate on that idea?
JS: The simple way to see that is, if every building was 100 percent equity financed, you’d almost never have a default. So leverage creates risk, and maturity risk on that leverage is the moment of truth. It's the moment where real estate owners often are exposed to the most risk.
Without a ground lease, if you had a $100 million building and borrowed $70 million, all that debt would come due one day five years from now.
If you do a ground lease, instead of a $70 million loan on your $100 million building, we will take $35 million of that $70 million out through the ground lease, and give it a 99-year maturity. So five years from now, instead of $70 million being due, you only have $35 million due. You’ve cut your maturity risk in half. Add these three things up - capital efficiency, cost efficiency, and risk reduction - and you can see how building owners can use ground leases to earn higher returns with less risk and fewer costs.
Why did it take so long for someone to correct what you make sound like very obvious inefficiencies?
JS: With the old ground leases, nobody ever talked about capital efficiency, or cost efficiency, or risk reduction. The industry of the past created ground leases with many provisions that don't fit with the modern capital markets, and those inefficiencies destroy value. So ground leases got the reputation that they hurt the building owner’s ability to finance or sell the asset.
As an example, one of the most damaging provisions in many old ground leases is the fair market rent reset, which creates all sorts of problems for building owners. If you have a fair market value reset in the ground lease’s rent in 10 years, then you have no idea how much rent you’re going to have to pay 10 years from now. A leasehold lender – the building owner’s lender – could say, “Well, your ground rent’s $3 million today, but it could go up to $10 million in 10 years. Therefore, I'm going to have to assume it's going to go to $10 million, and I'm going to lend you less money at a higher price.”
We heard horror stories from decades of these bad ground lease experiences – but realized that was exactly why there was such a big opportunity. By fixing all the flaws, we're going to reinvent the ground lease business to make it value-enhancing for building owners instead of value-destroying. And as soon as you eliminate all the value-destroying features, what's left are all the benefits we just talked about.