Why I Tripled Down On iStar

Summary

• iStar has more than doubled in value over the past year.
• Even then, it remains deeply discounted due to the rapid growth of its ground lease venture.
• It could be the (insert successful tech company name) of the REIT industry and priced at just around half of its NAV, the shares are still a steal.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

MicroStockHub/iStock via Getty Images

We first invested in iStar (NYSE:STAR) at ~$11.50 per share in August 2020.

We then doubled down at ~$17.50 per share in March 2021.

Will we triple down at $24 per share?

The answer is yes.

Generally, such a large and rapid surge in share price would give me pause, but not in this case.

I just tripled down and bought more shares of STAR with my company's brokerage account, which is separate from the HYL model portfolio.

Below, I explain why STAR remains one of the best investment opportunities in today's market.

But before that, here is a quick recap of our investment thesis:

Quick Recap Of Our Investment Thesis

iStar is a mortgage REIT that's in a middle of a major transformation.

Three years ago, it founded Safehold (NYSE:SAFE), which is the first and only publicly-listed ground lease REIT, and to this day, STAR owns two-thirds of its equity and takes care of its management against fees.

Turns out that SAFE was a major success. It has been one of the best-performing REITs since its inception and has grown its assets more than 11x in just a few years. Moreover, we think that this is just the beginning for SAFE. It has the potential to change how we invest in real estate and disrupt a $7 trillion industry. This short clip explains how:

Since STAR is its manager and biggest shareholder, it directly benefits from SAFE's success, but to this day, this success still isn't correctly reflected in its share price, causing it to be undervalued.

Below, I explain why I just tripled down on STAR:

The Discount Remains Intact As a Result of SAFE's Surging Value

With the share price more than doubling over the past year, you would expect the discount to have disappeared.

But that isn't the case because of one main reason: SAFE, which is 2/3 owned by STAR, has also nearly doubled in value over the past year:

Data by YCharts

When we first invested in STAR, it had a $0.9 billion market cap, and the value of its stake in SAFE was $1.8 billion, meaning that it was 50% undervalued based on its stake in SAFE alone.

Today, STAR has a 2x times larger market cap at $1.8 billion, but the value of its stake in SAFE is $3.1 billion, meaning that the discount is almost intact.

If the value of its stake in SAFE had not grown, then STAR would now trade much closer to fair value, but as a result of SAFE's success, STAR remains deeply discounted.

The Wealth-Creating Portfolio They Call "UCA" Has Grown Dramatically

Based on SAFE's market cap, STAR is still nearly 50% undervalued.

But does SAFE's market cap properly reflect its fair market value?

In the past, we have argued that SAFE also is undervalued, which means that STAR is even more discounted than it may first seem.

And as SAFE continues to scale, this discount grows even larger as a result of the portfolio-embedded unrealized capital appreciation or "UCA" in short.

What is that?

Under the terms of a typical SAFE ground lease, at the end of the lease term, SAFE will own whatever is on top of the land.

Since SAFE will eventually own it, they track the estimated present value of whatever is on top of their land and call this the "UCA."

Typically, the building is worth a lot more than the land, and therefore, each new ground lease investment grows the UCA exponentially.

In the first quarter, this was estimated to be worth $5.6 billion.

In the second quarter, it grew to $6 billion.

At this pace, it could well be in the $8-10 billion range in a year from now:

source

SAFE's market cap is today only half of that, and therefore, the growth in UCA is not properly factored into its valuation or that of STAR.

Since that STAR owns two-thirds of SAFE, the $374 million added over the last quarter mostly belongs to STAR. That's a lot of value creation in a single quarter for a company with a $1.8 billion market cap.

As STAR/SAFE continue to educate the market on the value of ground leases, we expect this value to be better reflected in SAFE/STAR's share price in the future. SAFE presents the math behind its UCA in slides 15 to 20 of its investor presentation.

SAFE Is Still Just Getting Started and The Hardest Is Now Behind

SAFE was created in 2017. It went public with a $0.43 billion portfolio, mostly contributed by STAR, and since then, it has grown 11x its portfolio size and gained strong market adoption:

source

That was by far the hardest part.

Back then, no one knew what the "modern ground lease" was, and SAFE had to educate the market to convince the first property owners to partner with them.

Now SAFE has proven itself and the real scaling of its platform is just getting started. SAFE could do another 10x and it would still be scratching the surface of its $7 trillion dollar market.

If it could grow so fast from 2017-2021, despite (1) having to educate everyone, (2) having poorer access to capital, and (3) not being nationally scaled, then we think that SAFE will do a lot more over the next five years.

Here's what they noted in their second quarter earnings call:

"I will tell you that we are busier than we've ever been. We're seeing this kind of thought that we've talked about really start to happen, the awareness of our product, our cost of capital, customer satisfaction, network effect. So as Jay alluded to, I think the second half of this year, going into early next year feels really good right now."

Put simply, the risk of SAFE becoming a failure has come down significantly, and the odds of it becoming the next big thing have risen sharply.

That justifies a higher valuation for both, SAFE and STAR.

The Attempt to Sell Net Lease Properties Has a Hidden Message

Recently, STAR announced that it was exploring a potential sale of its net lease portfolio, which is worth nearly as much as its stake in SAFE.

Selling those assets would be great because it would simplify STAR's portfolio and make it even more focused on ground leases.

But the hidden message here is that they have so much demand for ground leases that they need to unlock capital elsewhere to take advantage of the opportunity that's presented to them.

Coincidentally (or not), STAR announced a few weeks later that it had developed a new product that it calls "Ground Lease Plus" that will aim to accelerate SAFE's growth even further.

Essentially, STAR will originate ground leases earlier in the life cycle of assets on pre-development projects, and once the development meets shovel-ready criteria, it will sell those ground leases to SAFE.

This is a great win-win for both because:

• It will provide SAFE a new origination channel that will increase its pipeline and accelerate its growth.
• While it also will provide STAR with an opportunity to earn higher returns than it would with net lease properties, increase its focus on ground leases, and potentially also speed up the monetization of its legacy assets.

Just last quarter alone, STAR already lined up nearly half a billion worth of opportunities through "Ground Lease Plus."

This is a great opportunity for STAR, and given that they may have billions worth of such opportunities in the near term, selling the net lease properties makes a lot of sense.

The Story is Finally Getting Out to The Mainstream and More Analyst Coverage is On Its Way

We have been covering the opportunity in STAR since the summer of 2020. Back then, the story was a lot more complex, and STAR's management had not been nearly as vocal about their intentions.

Today, this is changing and analysts are finally seeing it unfold. Recently, B. Riley, a major investment firm, initiated coverage with a Buy rating and a $35 target price. They also made the following comment:

STAR is a diversified mortgage real estate investment trust trading well below net asset value "with multiple catalysts to erase that discount." The company is undergoing a "major transformation" to focus on growing its ground lease business.

In addition to that, they also initiated coverage of SAFE with a $100 price target. They added that:

"SAFE creates 40c for every $1 of equity it deploys, or effectively a 40% accretion to its investment. When this "value-creating" operating model is coupled with SAFE's "substantial premium to GAAP book value," a "virtuous cycle" is created in which "substantial accretion can be realized by issuing stock. We expect SAFE and STAR to merge by mid 2023 with SAFE being the surviving entity, which will likely create further synergies.

This news was significant enough to move STAR's share price by 10%.

As STAR (potentially) sells its net lease properties and reinvests in ground leases, its story will become even simpler, and the opportunity will be even clearer to a larger number of analysts.

Jay Sugarman Has Not Sold a Single Share

Jay Sugarman, CEO of STAR and SAFE, owns 2.5 million shares of STAR, and 105k shares of SAFE.

His stake in STAR is now worth over $60 million, and his stake in SAFE is worth an additional $10 million.

With STAR more than doubling in value over the past year, you would think that selling some of those shares would be the reasonable thing to do.

That's especially true when you consider that these shares represent the bulk of his net worth.

Even then, he has not sold a single share.

Jay has often talked about STAR/SAFE as a "generational opportunity" and clearly, this is not just talk. His personal wealth is on the line.

Bottom Line

STAR is a generational opportunity that has the potential to reinvent how commercial real estate is owned and I want to be a part of it.

I know it is up a lot already, but this could very well be the beginning of a multi-year (decade?) streak of significant value creation for its shareholders.

In some ways, STAR could be the (insert successful tech company name) of the REIT industry and priced at just around half of its NAV, the shares are still a steal. In the recent SAFE conference call, Jay said that they hope "this is a trillion-dollar business." No other REIT (VNQ) talks about trillions, especially so early on in their growth path.

After my recent additions, my position in STAR has become nearly as large as my position in STORE Capital (STOR), but at this pace, STAR will soon become my largest holding.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of STAR either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[clrodrick]

Am I the only one seeing SA getting buggy when it comes to updates on comments for articles? The email they send me shows a *bunch* of added comments for past articles I commented on, but when I click the link it takes me to top of article (not the comment section), and then when I scroll down to comment section it doesn't show any new comments at all!

This one though it worked it shows 7 new comments, but a whole bunch of others seem glitched out

[jara-mill]

@clrodrick - Nope you're not the only one.

[clrodrick]

@jaramill Sorry it is affecting you and others too. It's weird, sometimes SA shows an article has no new comments when I scroll down yet clearly there are they are just not highlighted in green like they should be. Hope SA fixes this

[guyb1]

Would love an update....is it time to quadruple down?

[R. Paul Drake]

@guyb1 also @comei@comeinvestwithme The price of STAR has presumably been dragged down by the massive drawdown in the price of SAFE. This seems to me to be an extreme over-reaction to fear of interest rate increases. It would take increases far larger than seem likely to have a big impact, and even then the continuing ability of SAFE to create massive new value would be a counterweight.

18 months ago STAR was massively undervalued compared to the value of its holdings in SAFE. Today that undervaluation is 28%, taking the value from STAR of the other assets. This includes the impact of some convertible bonds. There is uncertainty in the value of the STAR assets, which will be resolved as they sell. The higher-risk, higher-reward play is to hold STAR. The lower-risk play, which I expect to also produce high rewards, is to hold SAFE.

We have provided detailed analysis and discussed this in much more depth with our members at High Yield Landlord.

Best wishes... Paul

[danirak]

@R. Paul Drake would you suggest to sfap STAR for SAFE at this moment?

[R. Paul Drake]

@danirak Not familiar with sfap. Which to hold is personal, higher reward, higher risk holding STAR.
Paul

[comeinvestwithme]

STAR had a nice run, but then tanked - a lot more than the market. What happened? Is the thesis still valid?

[jara-mill]

@comeinvestwithme - I'm actually wondering myself. I'm sure Jussi will look into it. But remember the market tanked in general and now with the Fed signalling they are going to raise rates today just before the closing bell, the markets will react tomorrow morning.

[R. Paul Drake]

Getting lots of questions about the big drop in the price of STAR this morning. I know of no fundamental reason why there should be a big change in price. My best estimate is that it was still undervalued, even at the recent peak above $27. Best guess is that the computers over-reacted.
Paul

[jara-mill]

@R. Paul Drake - I go with your "best guess" :)

[goodsense1]

I find the STAR story very interesting, but need a better understanding about structure. If the ground leases provide a first lien on the property/structure being build on the land, how does that coordinate with the permanent financing provider also needing a first lien on the property being financed. Both can't have a first lien. Is the ground lease subordinate in the event of a default?

[R. Paul Drake]

@goodsense1 The landowner has the senior position. But the lender for the structures has specified rights to notification with time to cover any default by the ground-lease tenant. Part of making ground leases practical has been developing clauses that create acceptable protection for all parties.
Best wishes... Paul

[Rob G. in Vegas]

@R. Paul Drake Paul - any opinion on the big sell-off in STAR today (down 8%). I don't own any common (I do own two of the STAR preferreds) and am thinking of buying STAR after doing more research.

[DGI Dude]

I've continued to add IStar on price dips - I believe it will continue to gradually catch up to SAFE, and close the valuation gap between the two.
I also hold (and continue to accumulate) Agree Realty (ADC). They are making a point of increasing their Ground Leases, recently around 13% of their portfolio. Paul or Jussi, any opinion on ADC accumulation in light of their increasing Ground Lease focus?

[R. Paul Drake]

@DGI Dude The ADC ground leases are not much like the SAFE ones, being for much shorter terms. That said, there is a great deal to like about ADC. Our fellow author CashFlow Capitalist is a big fan and has produced several public articles. I personally am long STOR and NNN, but if I wanted three net lease REITs they would probably be the third one.
Paul

[FringDook]

Huge $SAFE offering ... Sometimes I find it disconcerting how every time $SAFE does a capital raise (quite often) $STAR gobbles up shares. It seems to make the relationship and correlating stock prices more opaque... a bit fishy. just my 2cents

[R. Paul Drake]

@FringDook iStar has consistently held 2/3 of the SAFE shares and is limited to 42% of the voting REITs. I would expect them to buy accordingly. To support the goal of Safehold to do $1B in new ground leases and sustain a debt ratio of 2/3, they would need to issue more shares than we see here. Though I have forgotten how much dry powder they brought into 2021.
Paul

[FringDook]

@R. Paul Drake do you think the fact that $star owns so many $safe shares drives the PPS of $safe up artificially ?

[R. Paul Drake]

@FringDook iStar has mostly been a neutral player in the liquid market for SAFE shares. They take 2/3 of the equity and hold it. They have made some open market purchases, mystifyingly, but that is small potatoes.
Paul

[LasVegasInvestor]

Are the concrete rumors about a merger with SAFE outside of B. Riley? I would assume STAR to benefit from such a merger as the CEO holds STAR not SAFE shares personally. What is your 12 months price target?

[R. Paul Drake]

@LasVegasInvestor When questioned directly about this, what the STAR and SAFE management has had to say to me about this is along these lines: The time for a discussion of alternatives is when SAFE is large enough that it could afford to internalize management. What the managers are doing is trying to create that situation, and to present a range of possible options to the independent boards of the two firms.

My thoughts: There certainly could be a merger of some sort, but there is also a great deal to be said for keeping SAFE simple. A lot may depend on what is left of iStar at that time.

Paul

[OptUndrWrtr]

@Jussi Askola @R. Paul Drake it seems like iStar formed SAFE because at the time they were a mortgage REIT that reposessed their deliquent loans and inadvertently expanded into being a net lease reit on the side. SAFE then was another new side biz. You mention in the article that they intend to sell off the net lease assets and just focus on the ground lease business. Since SAFE is no longer the side business but the main biz now, makes me think it would help their investment story if they just merged SAFE and STAR.

Or does it serve a purpose having 2 separate entities? Is it more that iStar is still a mortgage REIT that offers a ground lease option for financing, that separates land from improvements? So the borrower is purchasing the building and not the land (SAFE owns the land, and buys it/ leases it back to the building owner while STAR finances just the building?)

[R. Paul Drake]

@OptUndrWrtr Safehold is simple and secure by design, with the intent of being clearly understood and perceived by the market. In contrast, if you look at all their businesses, iStar is a complex mess as a result of their history. iStar does offer financing of buildings coordinated with financing of ground leases by Safehold, but that remains a small fraction of the total ground leases that Safehold does.
Paul

[John Windelborn]

I hopped back into STAR this morning after it dipped. Looking forward to this as a solid buy and hold. Thanks Jussi and Paul!

[Jussi Askola, CFA]

@John Windelborn Thanks for sharing!

[albertciampi]

Great, timely pick. STAR up today.

[Jussi Askola, CFA]

@albertciampi 👍👍

[clrodrick]

This is such an interesting article as I had lost touch with what iStar is up to. I have fond memories of them back in 2009 when I was buying up their preferred share at a huge discount along with NRF. Those two investments really helped propel my portfolio forward to where I stand today. Sadly though I forgot about iStar after that but will now take a much closer look!

[Jussi Askola, CFA]

@clrodrick I am glad to hear that you enjoyed the article. Please note that we have published several exclusive interviews of Jay Sugarman, CEO of iStar to the 2,000+ members of High Yield Landlord. Feel free to join us for a 2-week free trial to access all our research: seekingalpha.com/...

[Confused Capitalist]

Also, as a long time commercial real estate appraiser, I fail to see what is so unique about SAFEs ground lease approach. Here's what I routinely see in ground leases:
1. Long duration lease, check;
2. Escalators in rent over the duration, check;
3. Turn over of the entire asset at lease completion or upon rental default, check;
4. Protection of sorts to the lender for the building, allowing expanded time remedies against default (I.e. the mortgage lender can make good on the ground lease payment), check.

So I don't understand what is thought to be the "special sauce" that SAFE is promoting that's purportedly so different from other ground lease situations. Or is it just that "... we are the only REIT dedicated to this concept"??)

[R. Paul Drake]

@Confused Capitalist Paraphrasing what Jay Sugarman told me when we talked, iStar had accumulated experience with ground leases in all four roles -- landowner, their lender, building owner, and their lender. They found traditional ground leases unsatisfactory from all four perspectives. His claim is that the provisions in their "modern ground lease" address the deficiencies they experienced. Now perhaps they really did invent a much better mousetrap, or perhaps they are just really good at marketing. But either one can help you conquer the world of business and the financial advantages of ground leases ARE compelling for building owners.
Best wishes... Paul

[vekk]

@Confused Capitalist you know the Dave Ramsey story? He basically built — and lost— his first million following the Robert kiyosaki method of leverage and income property.
Out of the ashes— the Dave Ramsey baby steps were born— the safest, most sure-fire path to financial peace there is.

I believe this is the path of STAR and SAFE— if you look at STAR’s history as one of the largest mortgage REITS with a highly leveraged and high risk/reward business profile— then the headlong plunge into ground leases— where the operator has more to lose (cost of capital in building) than the leaser— I think it just makes sense.

Many other REITS offer ground leases— they just don’t focus their business on them. Perhaps SAFE’s structure is different— better even, but I’m not sure how— I’m sure Jussi can enlighten us though.

I am long STAR, PINE, PW

[Confused Capitalist]

@R. Paul Drake I guess that's fine to say they found deficiencies from all 4 points of view, but how does this knowledge (change in their process vs conventional) specifically create value for SAFE?

I read your other articles, and I'm struggling with the so-called "bond math" concepts, like:

1. Why should the value of the ground lease discounted at their cost of interest - 2.8% you say (whereas their filings say 3.99%), which the discount rate of an equity holder has to be higher than the interest rate ... (or the world is upside down);
2. If the longer term interest rate is held by Sugarman as stated to be 6% (at some indeterminate renewal point) then why isn't the value of the remaining number of years THEN simultaneously at THAT point in time discounted at that rate, (6%) plus, say, 150 basis points for equity vs debt?

I think there's a lot that's being floated here that doesn't pass muster. I agree and completely understand that land deserves a lower discount rate, particularly where there's some inflation protection, BUT, nevertheless, that rate cannot logically be below the corporate or typical borrowing rate UNLESS the escalators are perceived to be wildly in excess of likely inflation OR borrowing rates are thought to be falling considerably into the future. Neither of which seem to be the case here ...

[albertciampi]

Great article. Thank you.

[Jussi Askola, CFA]

@albertciampi I appreciate your interest.

[Confused Capitalist]

The other thing, in addition to my other comment, is SAFE expecting a 2% annual escalator ATOP an inflation adjustment seems unlikely. I'm sure the lessee can figure out that a 2% annual increase ATOP an inflation adjustment means his rent will be 40% more in real terms in 20 years, and 80% more in 40 years, and ... and ... etc. I'm very suspicious they've been able to routinely achieve this in their lease mechanisms, without some other distortion along the value equation (e.g lower base rent to start).

In fact, accordingly to the SAFE annual report, their rent escalators are CPI linked, not CPI linked plus additional escalator(s) (source: SAFES December 2020 10K annual report, page 8. They actually state that their rents MAY NOT keep up with inflation or market rents ...)

[vekk]

@Confused Capitalist a lot of these leases end up a base escalation OR CPI.. maybe it’s 2% or CPI— whichever is greatest. 1-2% seems fairly standard

[R. Paul Drake]

@Confused Capitalist The CPI lookback increase in the Safehold leases replaces the 2% escalator if CPI averages more than 2% over each decade, and is capped at a total of 30% (average of 3%). So there is a lag and there are limits. See the current investor presentation on the Safehold website. They have a nice illustrative slide.
Best wishes... Paul

[Jussi Askola, CFA]

Hi,

Thanks for reading!

We recently published our monthly portfolio review for members of High Yield Landlord. You can read a portion of it for free here: seekingalpha.com/...
Have a great day!

Jussi

[SFBay Investor]

Jussi,

Thanks for the article. Any thoughts on why the CEO of STAR stated in the recent earnings report that they had bought back shares of both STAR and SAFE over the quarter? I guess I don’t see any reason why anyone would buy SAFE at this point when you could buy STAR and get more SAFE for your money. This essentially appears to be the thesis of your article. If this is true, then why is management literally making this error seemingly?

Also, isn’t a plausible “bearish” argument for STAR potentially that SAFE at something like 60-80 times FFO is extremely overvalued, and accordingly, that STAR’s position is potentially overvalued as well? I get that SAFE is a great company with great growth, but valuation seems extremely high for a REIT. If SAFE can’t grow fast enough to meet its extreme Price/FFO valuation, then it would seem to me that this is a risk as well for STAR shareholders. In your article, you compare SAFE to high growth tech firms, which is maybe appropriate. I am thinking here that if someone told me: “Zach, buy Widget Co., and get shares of Tesla half-off indirectly,” I still might not want any, if that resulted in effectively buying shares of Tesla at a P/E of 800, instead of 1,600, both of which I think are absurdly expensive given potential growth in earnings of the company.

Thanks for taking my questions and I look forward to hearing your thoughts if you have time to share them.

Best, Zach

[Jussi Askola, CFA]

@SFBay Investor Hi Zach,

Thank you for your question. Note that we have discussed the buybacks with the CEO in exclusive interviews which you can find at High Yield Landlord with the 2-week free trial: seekingalpha.com/...

Concerning the valuation: we actually think that SAFE is undervalued. You cannot value ground leases with a P/FFO ratio.

[jara-mill]

I loaded up more on STAR after the exited position of IRT based on the Trade Alert. It's now my 2nd largest holding behind STOR.

[Jussi Askola, CFA]

@jaramill 👍👍

[Rob G. in Vegas]

@jaramill Obviously the sale recommendation of IRT was a mistake, as the stock is now at $25+. I held onto most of mine, but it sure does look pricey.

How high can these apartment REIT stocks go? They aren't tech stocks....

[jara-mill]

@Rob Grande - I did hold when Jussi issued the trade alert as it went down too much for me and wanted to get back in. Yes I agree on IRT, and had I not sold it all, I'd be at the $25/range. I think @Jussi Askola would recommend exiting....and reallocate to another apt REIT...AHH which I have initiated a small position.

[jgrever621]

Jussi,

Well, I am also long STAR with a full position (at least), and likely to add IF we ever see dips.
However, ground leases are not mainstream, have limited history (that I can find anyway), and thus have possibly unknown risks. While not a full negative, sure needs consideration.

Even thinking this, I have been adding, and expect to hold for some time.

With this reservation, I agree with you on the value of this stock.

[R. Paul Drake]

@jgrever621 I've been quite pleased to see two private operations -- ARES is one of them -- start up ground lease offshoots during the past year or so. Both were talking initial numbers in the billions.
Paul

[vekk]

@jgrever621 ground leases have been around for nearly as long as ground has. As far as I know STAR / SAFE is a first mover in the public REIT space market with this focus though.

Not a lot new with ground leases, just new at scale. Very safe for the land owner as the “tenant” has so much more invested. It is typical to offer lease extensions and “re-financing” on these leases— in effect, never actually surrendering the property asset to the land owner.

Long STAR, SAFE, PINE, PW, SPG, VICI, ET, SU.

[Jussi Askola, CFA]

@vekk I would also note that the SAFE ground leases are quite different from your usual ground lease.

[Delivery boy]

@Jussi Askola - Double check your first paragraph. Do you mean you first purchased in August of 2019?

[Jussi Askola, CFA]

@Delivery boy Thanks for picking the typo. We first bought in Aug 2020, but double down in March 2021*.