Inflation is on everyone's mind. According to the Bureau of Labor Statistics, the consumer price index (CPI) increased by 7.5% over the past year, the highest 12-month increase in the CPI since 1982. When inflation numbers start hitting 40-year highs, investors are going to notice and anticipate what is likely coming next: rising interest rates.
A rising interest rate environment can be particularly challenging for lenders. Inflation fears have likely been the cause of ground-lease real estate investment trust Safehold's (SAFE +0.00%) stock dropping 35% from its high a little over six months ago. While inflation is something that investors should be mindful of, it shouldn't be a reason to shy away from this alternative lender. Here's what most investors are overlooking when analyzing Safehold's business.
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Some inflation insurance
Perhaps one of the scariest things for someone that issues debt or other types of structured payments is high inflation. Take a fixed-rate mortgage, for example. If inflation runs high for several years, then the payments on that mortgage 15-20 years down the road are worth a lot less than they were at the time the mortgage was written.
Again, this can apply to any kind of structured payments: mortgages, corporate debt, annuities, and, in the case of Safehold, ground leases. At first glance at Safehold's business model, one might think inflation is arguably worse for the company because the length of the leases are so long (most ground leases are for at least 30 years and some are for 99 years). A ground lease is when the tenant owns the building, but leases the land it is on. When the lease expires, any structures on the land belong to the landlord.
Fortunately, the story isn't nearly as bad as one might think. As management has noted, a part of the ground lease contract is the ability to raise the rate of the lease using what it calls a 10-year CPI lookback. This mechanism helps to increase rental rates in the event of higher inflation. According to CFO Marcos Alvarado, if inflation is around 3% annually for a decade, then its lease rates will increase to offset all inflation.
It should be noted, though, that these contracts only protect up to 3% annual inflation. That doesn't sound great today when inflation rates are hitting 7.5%. Keep in mind, though, that annualized CPI inflation has only been above 3.5% once in the past 30 years (2008). We could see higher inflation for another year or so, but it will have to last much longer before it has a profound impact on Safehold's portfolio. So for those looking at Safehold as a long-term investment, there is still a lot of time before needing to worry about inflation.
Other benefits
In addition to the inflation protection built into Safehold's ground leases, there is another point investors should keep in mind when evaluating the company. Inflation, and more specifically higher interest rates, makes Safehold's ground leases a much more attractive financing option for real estate developers.
Cash is oxygen to a real estate development plan. So it matters immensely how much you can raise, the rate at which you borrow, and when it is due. In a rising interest rate environment, the cost of capital is going to increase, either through higher interest rates on debt or equity investors seeking more favorable returns.
In a world of rising capital costs, Safehold's ground leases look that much more attractive. Since ground leases last so long, developers and building owners have less worry of having to either repay or refinance when debt comes due.
NYSE: SAFE
Key Data Points
The more attractive the terms of a ground lease are relative to raising capital via debt or equity, the more likely this will incentivize more real estate developers to look at writing a ground lease. In turn, this could accelerate growth of Safehold's portfolio. At this stage in the company's young life, signing up lessors and expanding the portfolio is of greater importance than whether its current portfolio of leases will hold up in the event of 10-year annual inflation exceeding 3%.
Swim against the tide
It would make a lot more sense for investors to be pessimistic about Safehold if it didn't have any inflation protection built into its ground leases. That isn't the case, though. Its portfolio has some built-in protection for higher-than-average inflation over long periods of time, and the rising interest rate environment that typically accompanies inflation could entice more developers to take ground leases.
With all of that in mind, it's harder to see why so many people are parting ways with Safehold's stock. It could be their loss, though, as shares are now trading at 2.05 times book value.
