A New Real Estate Play for Income Investors

By Esther Fung Features Dow Jones Newswires

Risk-averse investors looking for income will soon have a new option to consider: ground leases.

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iStar Inc., a New York-based real-estate investment, financing and development firm, has spun off some of its ground leases into a separate real-estate investment trust called Safety, Income and Growth Inc. that is expected to raise $250 million from an initial public offering and concurrent private placement.

The shares started trading last Thursday on the New York Stock Exchange. Safety declined to comment pending the official closing of the deal. The deal will have its official close when the proceeds come through on Tuesday.

The REIT projects to pay an annualized dividend of 60 cents, which translates to a yield of 3% on the IPO price of $20, according to the prospectus.

The REIT is the first publicly traded company tied directly to leases on the land underlying commercial real estate. In many commercial developments, ownership of the land is separate from ownership of the building on top, and landowners collect income from the owners of the bricks-and-mortar buildings. Owners of hotels and office buildings, for example, often must pay ground leases.

The leases generate steady income for landowners, potentially making them attractive to investors looking for safety at a time when real estate and stock market valuations are high and interest rates remain near historic lows.

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"Ground leases are real estate's analogy to buying Treasurys," said Jim Sullivan, president of Green Street's Advisory Group. "When structured properly, they are perhaps the safest form of real estate that an investor can own."

The Federal Reserve raised interest rates in March and June as the economy continued to show signs of strength. Yet yields on 10-year Treasurys still hover around 2.15%. At the same time, an eight-year bull market for U.S. commercial property is fueling concerns that a correction is due.

Ground net leases are typically "triple net leases," in which tenants are responsible for development costs, property-operating expenses, taxes and insurance. In the event of an economic downturn, the last thing tenants likely default on is the ground lease because it could result in the landowner taking back the land as well as the building on top of the land.

"The upshot of this is that you're not buying the part of real estate that loses value -- you're getting the good part," said Michael Underhill, chief investment officer at asset management firm Capital Innovations LLC. "While the building on your land might be obsolete in 20 years, the land itself shouldn't be."

Capital Innovations isn't planning to invest in Safety because its business model doesn't meet the firm's corporate-governance standards, which include a dedicated management team, said Mr. Underhill.

Safety has a portfolio of 12 ground leases that are signed by operators of hotels in Seattle, Salt Lake City and Dallas, as well as office buildings in Detroit, a medical office building in Cumming, Ga., a multifamily apartment building in Milwaukee and a self-storage facility in Bloomington, Minn.

"We believe that rental income from ground net leases can provide us with a safe, secure and growing cash flow stream," according to Safety's prospectus filed with the Securities and Exchange Commission.

Two farmland REITs have similar models, Gladstone Land Corp. and Farmland Partners, which rent undeveloped land to farmers on a net-lease basis. Gladstone gained 1.3% so far this year, while Farmland fell 17%. The FTSE NAREIT Equity REITs Index rose 9.1% over the same period.

Safety's lease terms range from 30 to 99 years, according to the prospectus. These leases will have contractual base rent increases that may be linked to consumer price inflation.

"Our investment thesis is predicated, in part, on what we believe is an untapped market opportunity to expand the use of the ground net lease structure to a broader component of the approximately $7.0 trillion institutional commercial property market," the prospectus said.

Write to Esther Fung at esther.fung@wsj.com

(END) Dow Jones Newswires

June 27, 2017 07:14 ET (11:14 GMT)