Photography by Keith Barraclough
It has been five years since Safehold, a New York-based real estate investment trust that structures modern ground leases on US commercial properties, completed its initial public offering, raising $250 million to revolutionize a long-misunderstood part of the market.
Since then, the company has hit major milestones that include structuring its 100th ground lease and expanding its portfolio to $4.5 billion in assets under management. But this is just a fraction of what Jay Sugarman, Safehold’s chairman and chief executive, sees as the potential for modern ground leases.
“We think the ground lease industry could be a $100 billion to $500 billion market and we want to remain the leader,” Sugarman says. “We learned in the 1990s that when you fix a problem in real estate, you typically build a very large company.”
Sugarman, who is also the chairman and chief executive of iStar Financial, points to two logical factors that will help Safehold to exponentially scale its ground lease portfolio: the size of the opportunity and the ability to solve a problem for sophisticated commercial real estate owners who believe a property is worth more than the sum of its parts.
“We have a 75-person team working around the clock to help continue to innovate and re-invent this industry that has existed for a century but had really fallen out of favor with the commercial real estate world,” Sugarman tells Real Estate Capital USA.
“Every day we are competing with the rest of the capital markets to provide owners of high-quality real estate with better capital that enhances their returns. Our job is to provide the lowest cost of capital out there. We can demonstrate why it is better and we can show them how we used it in our own portfolio to create value.”
Safehold estimates the potential size of the US ground lease market is about $100 billion, compared with an institutional real estate market of roughly $7 trillion. While ground leases are not a fit for every sponsor, there is a sophisticated subset of practitioners that believes it is possible to enhance the risk-reward attributes of an asset’s components by splitting the land below a building from the physical property.
Sugarman, who observed how the evolution of the commercial mortgage-backed securities market and net-lease market revolutionized the commercial real estate finance market in the 1990s and early 2000s, had long been fascinated by the potential of the ground lease market. But it was not until mid-2016 that his light bulb moment came, and he figured out how to take what was known to be a broken, inefficient structure and make it applicable for today’s commercial real estate market.
“I was sitting with an investor and talking about what in the commercial real estate world needed to be fixed, what could become a big business,” says Sugarman. “While he was talking, literally, the dots connected, and I saw how we could turn ground leases into a billion-dollar business. We started to put the pieces into place and went public with Safehold less than a year later.”
The company works across most property types, including office, multifamily, hospitality, medical office, retail, industrial and student housing.
“We are looking at where there is a long-term trajectory of growth,” Sugarman says. “Where are the country’s education centers, functional centers, cultural centers, financial centers, technology centers? And then we look at the individual marketplace locations – where are the transportation nexuses? The financial hub? Where is a city’s heartbeat? Those are the places where you can look back in time at the major cities of the world and see their growth. The ground lease drafts off all of that economic growth and potential.”
From the ground up
The modern ground lease structure is widely seen as the biggest innovation in the commercial real estate finance industry since the first commercial mortgage-backed securities deal was printed in 1994. But that is because today’s ground leases are markedly different from their predecessors, with standardized structures and predictable rent resets, market participants tell Real Estate Capital USA.
“We think the ground lease industry could be a $100 billion to $500 billion market, and we want to remain the leader”
Historically, ground leases were concentrated in a handful of markets that included New York, Washington DC and parts of Hawaii where the state retained land but sold the right to develop it to individual sponsors. These ground leases were structured with 99-year terms that allowed for regular, substantial rent increases tied to the estimated fair market value of properties. As a result, the sector was out of favor with borrowers, who favored other financing options because of the lack of standardization and predictability in rent resets and the impact on the value of the physical asset.
This history meant that pitching the idea of a ground-lease focused company was not all smooth sailing, Sugarman says.
“It took a while to convince our board this was actually a very big idea. Lots of people, when they hear the term ground lease, turn the other direction and walk away. To their credit, our board took the time to understand the logic and why it was better for customers and better for investors. Their big question at the end was, ‘Why hasn’t anyone else done this?’”
The answer, in part, was the wide-spread negative perception market participants had of ground leases. But Sugarman was passionate about the potential for innovating and, more importantly, standardizing the structure in part because he had witnessed similar financing revolutions in the commercial real estate finance market since the start of his career.
“I was there for the beginning of the change of the financial markets in the early 1990s and the changes in the net-lease market in the early 2000s. We were confident in our ability to change people’s thinking, to highlight this transition from the old ground lease structure to a new one that worked for the customer and worked for the owners and not against them.”
There was also a comparison that made sense – the evolution of the sale-leaseback market in the corporate world, which learned 20 years ago to separate their operating businesses from their real estate assets.
“It is the same dynamic as separating the building from the land. But there were no companies that had the expertise, experience and knowledge to execute on it,” Sugarman says. “We had logic and the customer economics on our side. We could demonstrate to building owners that one plus one can equal more than two, and that it was possible to earn higher returns with less risk.”
And as part of this, Safehold had to convince potential users that its approach was different than what had gone down in the past.
“We had to convince them we were taking a completely different approach to the ground lease industry by making the customer – the building owner – our primary focus,” Sugarman says. “We had to have the perseverance to say, ‘We know it is better, we know customers will like it once they try it.’ A few customers started to see a competitive advantage within particular markets, in particular asset classes. And then people on the sidelines said, ‘Oh, that does actually work. They are actually creating a better capital source for us.’”
Safehold’s transaction size
Size of the existing US ground lease market
Potential size of the US ground lease market, as a share of the total institutional real estate market
Size of the US institutional real estate market
There has also been an evolution of thinking in the broader US commercial real estate finance market since the 1990s that eased the way for the adoption of ground leases, Sugarman says.
“Back in the 1990s on the finance side, I saw the mortgage market was sort of monolithic. There were mortgages and that was about it. What we had seen in the corporate world is that debt comes in a lot of different flavors. And if you give investors the risk-reward they want, you can make the sum of the parts worth a lot more than the original mortgage. That is the premise of CMBS – to package up single mortgages and give investors specific risk-reward choices.”
In addition to structuring new ground leases, Safehold has also worked with building owners to acquire old ground leases.
“We just completed a large one in Washington DC, where we took an existing lease that had a relatively short period of time on it with some old provisions that didn’t work for the customer or the finance markets. We worked with the customer to buy that ground lease, modify it and modernize it, putting into place a new ground lease for the next 99 years,” Sugarman says.
Servicing the market
As the company has grown, Safehold has always focused on client service – which Sugarman believes is key to getting deals across the line – and educating its clients about the structure.
Borrowers continue to be worried about the impact of a ground lease on property value, mainly because ground leases historically had provisions that were one-sided for a landowner. These issues included fair market value resets that were completely impossible for a future lender or owner to underwrite, Sugarman says.
“Historically, ground leases were put into place when someone owned land and a developer wanted to build on the land. The landowner said, ‘Here are my terms – take them or leave them.’ It created something really inefficient for both sides.”
In addition to educating clients and prospects, Safehold has emphasized that its modern ground leases have a standard format that makes it easier for borrowers and their advisors to digest.
“At each and every point, we walked through the process and showed how it works, showed how the documentation would work, how the leasehold mortgage would work. A lot of people would say, ‘What are you talking about? Ground leases have been proven to be value destroyers for building owners.’ Well, we are changing the entire story of ground leases into what it should always have been.”
One of the biggest changes is the standardization. “Every time a ground lease shows up, you don’t have to work through the documents. Standardization is powerful,” Sugarman adds. “Standardized provisions are two-sided in terms of fairness. There is also a predictability. We have taken each provision and tried to find a simple, standardized way for future lenders and buyers to easily underwrite.”
As the company has achieved scale, it has found that borrowers and their advisers are more comfortable.
“The more we do, the more comfortable more parties are, whether it is the lawyers, title companies, the finance companies or even when we’re doing a purchase or sale, the different counterparties. They know we have worked through the issues with multiple law firms, financing sources, multiple buyers and sellers, and it gives people comfort that we are taking that expertise and making the process better. That is one of our big benefits – that scale.”
The next hundred (or so)
As Safehold seeks to scale its business, Sugarman notes the firm has been fueled by repeat business.
“The best news I can tell you is the people who work with us tend to come back. Fifty percent of our business tend to be repeat customers and about 65 percent of our deal sourcing comes from sources that we’ve worked with before. In almost any business, if people don’t come back, you’ve got a problem.”
Five years and 100 ground leases later, Sugarman says Safehold still wants to refine the structure.
“The first hundred, we think we have created a gold standard ground lease. But we are still working to make it even better for our customers. I think there is a big value to being the biggest, most experienced. We have built that credibility with a large part of the commercial real estate market. When we say we’re going to close a deal in a timeframe, we are going to close.”
Safehold is working to launch new products as it seeks to expand its client base and assets under management.
“You’re going to see some things from us in 2022 that will really show people the power of this opportunity for this new asset class. We are working on transactions through a program we call GL Plus, which is taking a ground lease and getting it to a customer earlier in the real estate life cycle, when they acquire high-quality land,” Sugarman says. “We can put the ground lease into place early on, and this gives them some of the lowest cost of capital. As they build, the ground lease grows to meet their needs while they construct the building. The market is starting to understand how big this opportunity could be.”
The company has gone from zero to nearly $5 billion in assets to reach scale, to gain the experience and the credibility.
“We have spent thousands of hours trying to help people to understand this new tool that every building owner should at least be aware of. We’re not saying every building owner should do it, just like not every corporation should do a sale-leaseback on their real estate. But large parts of the market are going to say, ‘Wow, this is better. This is a way to enhance my returns, lower my costs and lower my risks.’ That is an innovation that gets adopted quickly. That was really important and now the goal is to go from $5 billion to $50 billion and we’re really excited to begin that journey.”
Bifurcating risk and reward
The idea behind a modern ground lease is simple: there is a risk-reward mismatch in the way commercial real estate financings have been structured
In a traditional financing, a borrower obtains a mortgage on the fee simple, which encompasses a physical asset and the ground below. But ground lease proponents believe there are substantially different risk-reward profiles for a physical asset and the ground below.
In a Safehold ground lease, the company will work with borrowers to bifurcate the building from the land. Safehold will then acquire the land and lease it back to the borrower on a 99-year lease at a low initial yield. The benefit for the borrower is the ability to redeploy the proceeds from the sale of the ground lease into other investments. Ultimately, when the property is sold at the end of the borrower’s hold period, Safehold will retain ownership of the ground lease.
By the numbers
A traditional financing for the acquisition of a $100 million office building might be structured with a 25 percent equity commitment and a $75 million senior mortgage.
With a ground lease, however, the fee simple is split into three components: the ground lease, which makes up as much as 35 percent of the total capital structure, the leasehold mortgage, which accounts for 35 percent to 65 percent of the capital structure, and the equity, which makes up the remainder.
While the purchase price for the building is the same at $100 million, the borrower benefits in three ways from a ground lease structure. First, the borrower’s equity commitment is smaller because there is no need for equity on the ground. Additionally, the borrower needs a smaller senior mortgage, which reduces the financing cost. Finally, the borrower can redeploy proceeds from the sale of the ground below the property into other investments.
Past versus present
The biggest difference between traditional ground leases and ones being written today that affected lenders is ground rent reset clauses, notes Andy Singer, a principal at Avison Young. This can come into play when the use of a building changes to a more valuable one.
“The result was that when you applied the percentage of value called for in the lease to the new use, the ground rent soared and could not be paid by the lessee,” says Singer.
“[Today] it is far more likely that the lease would have stipulated increases in the ground lease.”