As a pioneer in ground-lease investments four years ago, Jay Sugarman is experiencing validation now as a number of new funds take shape to tap into what he considers a multitrillion-dollar market. But like other commercial property sectors, valuation disruptions brought on by the pandemic have added new layers of risk to go along with enticing opportunities.

Ground leases have been popular in major U.S. cities where high-rises often come with sky-high property values. Real estate investors sell and lease back the ground underneath the building as a way of lowering the amount of capital needed to finance ownership or development of the building on top of the land.

Prompted by what he saw as escalating land values in markets across the country, Sugarman, then and still chairman and CEO of iStar, a commercial real estate finance company, began in 2016 exploring the concept of separating out ground-lease investment financing activities. He eventually launched Safehold, a new real estate investment trust that went public in 2017.

The business fared well until the pandemic dropped ground-lease investment activity to its lowest level in years. Then, markets loosened in the fourth quarter, according to CoStar research. For Safehold, acquisitions increased to $331 million, much higher than the third quarter’s $34 million, the company said. It was Safehold’s largest quarter to date by number of deals. Other firms took notice of the rebound as well.

“We saw when COVID first hit a pretty significant pause in all real estate transactions. Post-Labor Day, we started to see that change,” Sugarman told CoStar in an interview. “People started to get back to business. We started to see a lot of transactions that we had been working on finally close. And I think some people seeing that we were starting to get a lot of deals done, thought it might be a chance for them to get in as well.”

Indeed, other firms are looking to get in on the action.

Ares Management of Los Angeles and Regis Group, a London-based real estate private equity investor, launched Haven Capital as an investment vehicle to originate and acquire ground leases in the top 50 markets in the United States. Haven Capital, based in New York, has $1.2 billion in buying power to acquire contracts.

Montgomery Street Partners, a Dallas-based commercial real estate investment firm, this month formed a new ground-lease venture with a U.S.-based Fortune 500 global insurance company to purchase ground leases in the top 50 U.S. metropolitan areas. The REIT intends to deploy $1 billion of gross capital over the next several years.

“This is an extremely compelling opportunity for investors to gain access to long-duration, inflation-protected real estate assets that are cycle tested,” Murray McCabe, managing partner of Montgomery Street Partners, said in a statement. “Ground leases have evolved to become a more acceptable and mainstream financing tool in both primary and secondary markets as real estate owners and developers gain a greater appreciation for the merits of the product.”

Rather than seeing new investors coming into the sector as a challenge, Sugarman sees it as a confirmation of why he launched Safehold. With a current market capitalization value of about $4.45 billion, there is plenty of room for others to come in.

Even with disruption from the pandemic, “we continue to believe that the opportunity is very large and from an owner’s perspective we think the efficiencies and higher-return, lower-risk opportunity for that is pretty unequivocal,” Sugarman said.

This month, Moody’s Investors Service and Fitch Ratings initiated credit research on Safehold and assigned investment-grade credit ratings. Moody’s assigned an issuer rating of Baa1 with a stable outlook, and Fitch gave an issuer default rating of BBB+ with a stable outlook.

“From our standpoint, it’s one more validation of what we’ve been building for the last four years,” Sugarman said of the ratings.

Safehold's recent results also brightened the outlook for its shares, wrote Ki Bin Kim, an equities analyst for Truist Securities. “This is an indication that [Safehold’s] acquisition pipeline has likely improved and perhaps we could start seeing [Safehold] returning back closer to the billion-dollar mark for annual acquisition,” he said in a report emailed to CoStar. “We were further encouraged to see [Safehold] deal with eight new clients.”

Ground leases aren’t without their risks, according to credit rating agency DBRS Morningstar. Agreements tend to be long, and ground-rent payments are typically designed to escalate over time. Thus, building revenues need to keep pace with the increases. That has been a challenge during the pandemic, and DBRS noted several instances of loans backed by ground leases in commercial mortgage-backed deals that are delinquent or being monitored for potential distress.

DBRS flags any ground-lease payment that begins to exceed about 20% of the property’s estimated gross income because, over time, the rising payment obligation could put the property in a hole it can’t climb out of, the agency said.

It’s not an issue that has plagued Safehold, however. In assigning its investment-grade rating, Fitch said Safehold has not experienced any defaults or deferrals on its ground leases since inception.

Going forward, Compass Point stock analyst Floris van Dijkum sees distressed property owners offering some ground lease rights to a new wave of investors. He's been testing his thesis in questions during recent earnings calls.

During one, John Kite, chairman and CEO of Kite Realty, a real estate investment trust specializing in retail properties, told van Dijkum that his company has a significant amount of ground-lease operating income and that there is potential to make money from it.

Van Dijkum noted in his subsequent earnings commentary that in the fourth quarter Kite purchased the Trader Joe’s-anchored Eastgate Crossing in Chapel Hill, North Carolina.

“Management indicated it will look to fund the Eastgate acquisition through asset sales, perhaps through the monetization of part of its $16 million of ground-rent income. This income would likely trade well inside the cap rate paid for Eastgate that had a vacant Stein Mart" space, van Dijkum said.

Van Dijkum put a similar question to Jim Taylor, president and CEO of Brixmor Property Group.

“You’re right,” Taylor told van Dijkum. He went on to describe attractive pricing for ground-lease buyers and a “great opportunity” for his company to sell an outparcel at a 5% capitalization rate — and putting that capital “back to work” at a 10% rate. “That’s a huge multiplier,” he said.