iStar Stock: I Bought The Dip, Here’s Why (NYSE:STAR)

phrase buy the dip handwritten on night wet window glass surface

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In a recent exclusive interview with iStar Inc.’s CEO (NYSE:STAR), we noted that the shares of the company had been one of our worst performers in 2022.

For those of you who aren’t familiar with the company, STAR is the manager and biggest shareholder of Safehold (SAFE), which is the only ground lease REIT in the world. This is by far its biggest investment, and therefore, STAR is considered to be a ground lease REIT by proxy.

Now unfortunately for STAR, ground leases are perceived to be some of the most inflation-sensitive assets because their leases are up 99 years long and only provide limited rent hikes.

If your rent hikes are limited to ~2%, but inflation is at 8%+, you have a problem. Your cash flow is losing value in real terms, and as a result, your ground leases also aren’t as valuable anymore.

That’s what the market is thinking… and it is the primary reason why the company’s share price has been dropping:

iStar stock Chart
Data by YCharts

But this is actually wrong.

Yes, if you ignore all other factors, then high inflation would be a problem, especially so if it remains high for a long time to come.

But there are many mitigating factors that are important and need to be taken into account. In what follows, we discuss what the market is today missing about STAR’s ability to protect itself from inflation:

2-1 Fixed Rate Debt Financing Offers an Overlooked Inflation Hedge

I will start with this factor because it appears to be the most overlooked.

The market is only worrying about the asset side of the balance sheet and forgetting about the liabilities, which in this case provides a great inflation hedge.

SAFE finances its ground lease investments with only ~35-40% equity and the rest comes from fixed-rate long-term debt financing. In the last quarter, SAFE accessed 30-year debt for the first time, and its debt has on average 24 years left until maturity.

This provides a valuable hedge because all of this debt is now being inflated away.

If SAFE borrows a million dollars today, it will still need to pay back only a million 30 years from now despite all the inflation. In real terms, the same million will be worth a lot less of course.

So in essence, SAFE has put together a large portfolio of ground leases that enjoys at least some inflation protection, and it finances most of it with fixed-rate debt that’s being inflated away.

Appreciating assets combined with depreciating debt offers a good hedge for the equity, especially so when you are nearly 2-1 leveraged with fixed-rate, long-term debt. That’s why the CEO made the following comment in the most recent conference call:

“When you run that all through the model, it’s actually one of the reasons we love this business is you have quite a bit of inflation capture that you’re not going to be sharing with your liabilities that are already in place.” [emphasis added]

CPI Look Back Offers Delayed Revenue Upside

SAFE typically has 2% annual rent hikes in its leases and in addition to that, it also has periodic upward rent adjustments in the form of capped CPI lookbacks when inflation stays above 2% for extended periods of time.

This appears to be misunderstood and yet, it is an important element of the company’s protection against inflation.

What this means is that every 10-years, they go back and calculate the cumulative inflation of prior years. If it exceeds 2% per year, then they are able to adjust rents higher. Here is what the CEO commented:

You can imagine the bulk of the 10-year CPI lookbacks that are in place in the portfolio don’t really start to hit until that 2029, 2030, 2031 period. So in some respects, we think of it as a CPI bank, high CPI in the interim, we can kind of calculate going out. [emphasis added]

These CPI lookbacks are generally capped between 3.0% – 3.5% per annum compounded.

Of course, if the cumulative inflation growth for the lookback period exceeds the cap, then the excess is not captured by the CPI lookback. But what’s the likelihood that the inflation rate remains so high for such a long period of time?

Yes, today, inflation is way higher at 8%+, but this is largely due to temporary issues caused by the pandemic and war in Ukraine, which won’t last forever.

Even despite the high current inflation, the market expectation is for only 2.49% annual inflation over the coming 30-years according to the Federal Reserve.

SAFE’s ground leases would provide protection against that, especially so when you consider that it is 2-1 leveraged. This is why the CEO made the following comment in the most recent conference call:

“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.” [emphasis added]

In that sense, ground leases are closer to TIP securities with the added benefits of being partially financed with fixed-rate long-term debt.

Rising Replacement Costs Increase The Value of Its “Unrealized Capital Appreciation”

As a ground lease investor, you only own the land and rent this land to a building owner who has the ownership and control of the improvements on top of the land during the entire lease term.

But once the lease expires, all the improvements revert back to the landowner at no cost, and therefore, the value of these improvements matters to us as well. Typically, the land is worth 30-40% of the total, and the building is worth the other 60-70% so it is very substantial.

SAFE tracks this value closely with what it calls the “Unrealized Capital Appreciation.” It estimates this “UCA” by looking at the current value of the buildings, adding a growth rate to them, and then discounting them back to present value.

Currently, they estimate that it is worth $9.4 billion and its value is growing very rapidly as they grow the portfolio:

Growth of UCA

Growth of UCA (iStar)

That’s very significant when compared to the company’s $2.5 billion market cap. It essentially means that they estimate that their “UCA” is worth a multiple of their current share price, and that still does not give any value to their current cash flow.

Why isn’t the market giving it any credit?

Most investors appear to believe that the “UCA” is a lie and that its real value is close to zero. After all, what’s the present value of a building that you will receive 99 years from now? Some analysts have previously argued that if you discount its value back to today, it isn’t meaningful.

But that doesn’t really make sense.

It is the same as saying that a trust fund that you will receive sometime in the future has no value today because you don’t have access to it. Sure, you may apply a discount to its estimated value because you can’t access it today and there is no market for liquidity. But you wouldn’t value it at zero, especially if the value of that trust fund is expected to grow over time at a rate that surpasses inflation.

SAFE proved this point over the past quarter by selling 1.37% of its UCA at a $1.75 billion valuation to a group of leading private equity, sovereign wealth, and high net worth investors. The CEO openly says that these investors received a large discount, but this is largely because these investors will now help SAFE unlock this value by spreading the word to other investors, educating the market, and preparing a future public market listing for the UCA.

iStar monetizes the value of the UCA

iStar monetizes the value of the UCA (iStar)

This provides further inflation protection to SAFE shareholders because of two reasons:

For one, the market isn’t giving any credit for the value of the UCA and so whatever they can do to unlock its value should have a positive impact on SAFE’s future share price.

And for two, the UCA is growing at a rapid pace and the high current inflation will only accelerate this growth. As the CEO noted:

“Increases in replacement costs have generally led to long-term increases in value for well-located real estate in major cities… We’ve seen this dynamic in our research on many of the assets in our existing portfolio. So Caret (UCA), 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.” [emphasis added]

The CEO also noted that this recent transaction is the “first of many” as they will seek to unlock its value by closing new transactions and educating the market.

SAFE is Not Just a Passive Pool of Ground Leases

There is one more factor that provides long-term inflation protection.

We think that the market is making the mistake of seeing SAFE as nothing more than a pool of ground leases.

In reality, it is much more than just a passive portfolio and therefore, its inflation protection should not be judged alone based on the characteristics of its current portfolio.

SAFE is also a spread business and this improves its inflation protection as it is able to target much faster growth than what its individual leases would imply.

SAFE grew its EPS by nearly 30% year-over-year in the first quarter and most of this growth came from raising new equity and debt and reinvesting it in ground leases at a positive spread.

Safehold continues to grow at a rapid pace

Safehold continues to grow at a rapid pace (Safehold)

29% is obviously far greater than the current inflation rate so that’s additional protection.

Currently, SAFE has $1.15 billion of liquidity to conduct more such transactions. Once that’s allocated, SAFE may have a bit of a hard time growing through accretive spread investing in the near term due to the shifting interest rate environment and the higher cost of equity, but this is also only a temporary issue. The management has already noted that it is able to pass higher rates on its new ground lease originations.

Finally, if SAFE can sell a larger portion of its UCA to other investors, this could unlock a lot of cheap capital for the company to close more ground leases. It is still an untapped source of capital that should play a growing role in SAFE’s growth going forward.

Bottom Line

The bottom line is that STAR enjoys better inflation protection than the market is giving it credit for. The market is focused on the fixed rent hikes but appears to ignore or at least overlook how the 2-1 fixed rate leverage, CPI lookback, the UCA, and spread investing offer additional inflation hedging benefits.

The share price of SAFE has dropped significantly over the past months and it has also dragged STAR’s shares lower.

It is of course impossible for us to know how STAR will perform in the short run, and the sentiment is clearly quite negative at the moment, but our long-term investment remains intact, and we continue to think that STAR will be one of our most rewarding investments over the coming 5 years.

Patience will be needed, but we have a lot of it and will use this recent dip to accumulate a larger position.

Morgan Stanley recently gave SAFE a $140 price target. If it got there, STAR would more than triple in value. Will this happen in 2022? Probably not. But over time, it is achievable and it wouldn’t take a decade. Therefore, STAR remains one of our favorite REIT (VNQ) investments.

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