Building a Moat Around Sky Harbor Group with Tal Keinan, CEO of Sky Harbor Group $SKYH

Sure, Ben. So yeah, this came out of really my personal story, personal experience. I continued flying civilian after I got out of the military, and in 2015 I was able to actually purchase my first aircraft. I was on Wall Street at the time that I actually bought that airplane in Australia, and I only started looking for hangar space after arriving in New York with the plane. I found myself kind of in this panic. There's a waiting list of 12 different airports around New York City. There's zero hangar space available. I got very lucky. Somebody sort of graciously helped me out in a month-to-month hangar that I was in until earlier this year, since 2015. Finally moved to a different space, but it did leave me curious. What's going on here? You've got an industry that funnels a lot of capital through it. You'd think that the market would take care of any sort of supply-demand mismatch like that. And it became very clear as I started looking into this, really just as a curiosity, this wasn't a business idea. This is a chronic structural issue in business aviation in the United States.

It's true in other jurisdictions as well, but where we are in the United States, it's totally common knowledge. I was kind of the last person to get the memo. That was very well known in the industry. It's probably the least controversial statement you could make in business aviation: there is a structural, chronic deficit of business aviation hangar space. So I took some time off to write, and the guy who we actually installed as an interim CEO at my company was better than I was, so it's clear I wasn't going to go back there full-time. I've remained active on the board but not full-time. I said, you know, I've been really, really getting increasingly furious about this hangar opportunity. We can talk about it later, there's a qualitative opportunity as well, but the quantitative is really kind of the big, big, big driver of this business. There's simply a gaping deficit, many millions of square feet. So we started the company in 2018. We went public in 2022 through a SPAC merger, SPAC managed by Boston Omaha. And the fundamental problem is that lack of space. Again, if we have time at the end, happy to kind of explain what our thesis is as to why that came about and what's perpetuated that issue for really decades now. It's just becoming more acute. That's your sort of need-to-have problem. There's a want-to-have problem as well, which is the sort of legacy business model for business aviation hangar space, which is the FBO model, the fixed-base operator model. Really, I think you can think of it as a hotel where you can live, right? But FBOs are primarily structured to fuel transient aircraft. That is their primary function. You can live at the hotel, and that's what the vast majority of people do today, but it's not necessarily ideal for every flight department. There are those for whom it's fine, it works just fine, and there are others for whom having a home actually makes a lot of sense. As we kind of got deeper in and really began learning our own business in a more profound way, it became clear that you need to fuse the real estate and the service offering together. That's got to be planned from the start to create something that's actually quite unique and solve that want-to-have problem. Again, we could keep going with the legacy model, but there is a better way for a lot of the aviating public.

Sure. So this problem begins in the 1930s, where the federal government builds 13,000 airports across the United States. And at the time, you didn't have a big enough aviation industry to justify that sort of infrastructure project. This was really a New Deal employment scheme more than serving a critical infrastructure need. So you end up with this surplus of airports across the United States, and that actually ended up serving us well during the war, in that the U.S. was able to out-train everybody on pilots. The U.S. Army Air Force, the U.S. Navy were putting out pilots at a rate even faster than the Soviets. And your bottleneck in training pilots is runways. That's what you need. The airplanes, we were making hundreds of thousands of airplanes a year during the war. Instructors, you can mint almost as quickly as you can mint pilots. It's runways that's the bottleneck. So that's actually an interesting story in itself, but not for us. But after the war, that system as a system fell into irrelevance. The federal government, by necessity, has to think in broad terms. You're not looking at and saying, okay, Republic Airport on Long Island is interesting, that's an airport that'll stay in the system, and an airport that doesn't get much use in North Dakota, not so interesting. The entire system was divested of and all of the airports were handed over to local governments.

So today you're in a situation where almost every airport in the country is owned by a municipality or a county. There are few airports that are owned by states. There are no federally owned airports, and there are virtually no privately owned airports. That's who owns the airports in the country. And local government tends not to run huge cash surpluses, so the investment in the airport has been kind of neglected. Now, decades ago that became very evident that these airports, particularly what we call general aviation airports versus commercial airports, which is a regulatory distinction we can talk about as well, those airports are not self-sufficient financially. They can contribute massively to economic development in a region, for sure, but as standalone entities, they don't make money. They can't really make money. A commercial airport can make money from landing slots, automobile parking fees, concessions, especially after 9/11 where there's a much longer window between security and boarding, you kind of have a captive audience in them all. So there are definitely ways to make money at a commercial airport, of which there are 489 in the country. But the general aviation airports can't really make money. They require federal subsidies in order to subsist.

So there's about 3,000 airports in what's called the Airport Improvement Program, which is an FAA-administered program that provides the critical infrastructure that keeps an airport functioning as an airport. Anything that has to do with a runway, that could be a runway extension, occasionally a new runway, a runway resurfacing, any kind of maintenance on runways, that's federal dollars. Major taxiways, federal dollars. Taxiways that intersect runways, federal dollars. But that does not include things like hangars. Hangars are not in the AIP program. Now, the municipalities and counties typically have an incentive in having hangars on the airport, because if you want to maximize the economic development benefit of an airport, you typically want large business jets to base there. There are jurisdictions like Texas, California, Virginia where there's an ad valorem tax on aircraft, which is a very significant, actually often the biggest direct revenue driver that an airport has. But even where you don't, like in New York, there is no ad valorem tax on aircraft, the economic development benefits of having aircraft based at your airport, that's jobs, that's driving local businesses from the gas station to the dry cleaner to caterers to maintenance shops. You want those airplanes at your airport, and they're only going to base at your airport if you have hangars.

So what has the solution that the industry has sort of defaulted into, and this has been the case for decades, is that the airport sponsors, those cities and counties that own the airports, will confer fueling rights on FBOs, fixed-base operators, the largest two chains of which are Signature and Atlantic. Those are the companies that I described earlier as hotels for aircraft. They make their money from fuel. And what an airport sponsor will typically do is impose a certain minimum amount of construction of new hangar on the airport in order to confer a fuel license onto an FBO. What's ended up happening, though, is the FBOs typically have a lower square-footage target than the airport sponsors have. Again, they make their money outdoors. You're not allowed to fuel an aircraft indoors, that's a fire code issue. So you're making your revenue on the black area behind me, not inside the white area. We make our money indoors, they make their money outdoors. So you end up in a situation where less hangar gets built than is actually needed. And there's all sorts of solutions, again, there's a bit of a moral hazard problem in the industry. All sorts of solutions that benefit the current players, they don't necessarily benefit the aircraft owners or the taxpayer for that matter, but they do benefit a lot of the players.

Like repositioning. So if you think of Manhattan-based aircraft owners, they might fly in and out of Teterboro, but in most cases the airplane doesn't live at Teterboro. Therefore it might live in Bradley, Connecticut, or Bridgeport, Connecticut, or Lehigh Valley, Pennsylvania, and will reposition into Teterboro to pick up their customer. So if you're in the fuels business, that's a good trend, because repositioning flights consume a lot of fuel, they're conducted at low altitude. If you are the aircraft owner, that's pretty expensive and it's logistically challenging. You need to manage crew hours. If you're flying to Europe or Asia from Teterboro, you've got a certain number of hours that your crew is allowed to be on duty. If they started their day in Trenton, New Jersey, repositioned to Teterboro, had a 90-minute to two-hour turnaround time at Teterboro, that's eating significantly into their hours. So on long-haul flights, you might need an extra crew. It's logistically challenging and it also wears on the system. Air traffic control, particularly in these congested markets, has to manage four operations for every round trip rather than two, because the airplane is not based at the airport that it's operating out of. So kind of put all that together, that's really where your deficit comes from. And up until now, I don't think there's really been an incentive to address that. But if you approach it as a real estate company, you actually do have an incentive to address it, and it turns out that can actually be a pretty good business model.

So, it's an interesting question because you can count the number of aircraft, and we do. You can count the square footage of aircraft, and that's really for us the best proxy for demand. So we track that: number of aircraft times length times wingspan. And what you see is, this is not a new problem in the industry, but in the 10 years before COVID-19, we added about 30 million square feet of airplane to the U.S. business aviation fleet. And that's net, right? That's new entrants minus retirements from the fleet. So it had been growing at about 3 million square feet per year. By the way, I don't know that anyone else counts this, because I don't think anyone else really cares about that particular metric, but to us, number of airplanes is not really the whole story. The fact that airplanes get longer every year, their wingspan gets wider every year, and actually critically, their tail height goes up every year. Every single year airplanes get bigger, means that the square footage is actually growing faster than the number of aircraft in the fleet.

Since COVID-19, there's been a massive surge into business aviation, both on the corporate and the private side. The backlogs are extremely long at the aircraft manufacturers. There's a huge waiting toward the large, wide-bodied aircraft. So again, the square footage is going up. I don't know exactly how much, we don't have data for the last couple of years, we will eventually, but it's clearly north of 3 million square feet per year now. Supply is much more difficult to gauge. So we actually count the number of hangars in an airport and in a metro center that we're interested in, and we keep that very proprietary. I don't think anyone else has that data. But what's important is the national number, the national measure of hangar square footage is not really as relevant as the square footage of aircraft, because hangars that are built in places with lower relevance, I'm not trying to pick on North Dakota, I keep using that euphemistically as a place where there's less demand, but I think that is the case. A hangar in North Dakota should be counted very differently from a hangar in the New York City area, basically Southern New Jersey to Northern Connecticut, that's the New York area for aviation. That's really what's interesting to us. The airplanes, they're mobile assets by definition, they will go to where they're the most relevant. Hangars are where they are. And so whatever deficit we had 10 years ago, it's a lot more acute today, and we think the pace at which it's getting more acute is growing.

Yeah. So, had you asked five years ago, I would have said we're a real estate company or real estate infrastructure company. Today I have to say we're both, and that's not exactly by design, but I think it does open a couple opportunities. We're a real estate infrastructure company in that, look, what we do fundamentally: we acquire land, we develop our campuses on that land, and we lease them out to corporate, private, and some government residents. Our revenues are measured in rent, that's the vast majority of our revenues. We do other things, but rent is really the long arrow of it. We measure our unit economics in terms of yield on cost. We're like a real estate company in that respect. We did realize early on, however, that in order to really be as relevant as we can be to our tenants, our residents, we have to offer services. And that includes fuel. We can't be subject to somebody else's fuel pricing on a field, because whether they do or not, and maybe they don't always, aircraft owners should consider their total cost of basing an aircraft, which has two big components: the rent you pay for your hangar space and the fuel that you consume.

So if those are being bundled, then it's very important that we have a handle on both in order to provide the highest value to the residents. We saw that originally as just kind of a necessity, kind of like you can't get into the cold storage business if you don't have access to consistent power supply. That same kind of thinking. But that's evolved into something very different. Our service offering has become perhaps one of our biggest differentiators. Now, they're tied together in that you can't really provide our service offering without controlling the real estate. You've got to be able to design the hangars and just as importantly design the campuses themselves in a way that allows you to provide this very specific, proprietary service package, which we think is a very big differentiator. So I'm glad we're actually having this discussion today, because I'm allowed to say now, we announced actually our first brownfield acquisition, which is at an airport in California. It's called Camarillo, it's just west of Los Angeles. What allows us to really make that work, it's a great facility, it happens to line up in terms of the physical architecture of it with the Sky Harbour model. We can totally roll out our service at this new facility and really completely change the offering. So I would say we have become, in many ways, an operating company, a service company. When I think down the road, what does this look like, and people often ask about exit, we don't really think about it in such precise terms, but this might be two companies down the road. This could be a real estate portfolio, which at that point would probably be structured as a REIT, and then a service company layered on top of that that is perhaps providing this suite of services in locations that are not necessarily Sky Harbour. Again, that's way down the road, but clearly it's become a big focus for us, and it wasn't at the beginning.

All right, that's a great question. Developable land, it's not just land, it's developable land, because there's a lot of regulatory hoops to jump through if you're going to be developing on an airport. Developable land is absolutely constrained, you're right. We look at the question from the bottom up, though. This is not a question of looking at a map of the country and trying to gauge or predict how much land there will be at the average airport. It's very, very specific airports. So we have a database with hundreds of airports across the United States. We built it years ago, we're growing it constantly, but that database includes the specific land that we're targeting at every identified airport. And again, there are hundreds of those. So we're less concerned with what the total available land is in the country and more concerned with specifically this is the land that we want to develop on. In most of those cases, we've actually been in the process of securing that land for years now. Four or five years in some cases. There's a long gestation period in these processes, longer than I originally anticipated. It's also more complicated and more expensive than we originally anticipated. But it is, you're asking the right question. That is the binary threshold to this entire business. You want to build for cheaper, you want to operate better, there are definitely other metrics that you want to target, but the binary entry ticket is: can you get the land or not? Luckily, we started a long time ago, but this has been a much longer gestation period on average than we expected.

Yeah, well, so I'll give you back of the envelope, and our filings include a lot more detail. So if anyone's interested in looking at that, then you can definitely get deeper into the economics. But once you get the land, remember, you're sitting on a lease. You're not allowed to own land on a federally funded airport. Our average ground lease is about 50 years, but we're happy with that. I think it's actually a good model for us to lease the land. So once you've acquired the land, figure it costs you between $250 and $300 per rentable square foot to actually put up our campuses. And I use that metric of rentable square foot because it makes it much easier to think in terms of yield on cost when you do that. Obviously, there's a lot of square footage we develop that's not rentable. There's apron where airplanes taxi, there's car parking, there's a lot of stuff that's not rentable. But we think of it all in terms of rentable square feet. So, depending on the jurisdiction, figure $250 to $350 all-in development cost per rentable square foot. I can circle back later if we want to get into how we're trying to get those costs down, because that is a key thrust in the business right now. You lease that land, on average, at call it $45 per square foot, triple net. And that's, again, there's a little bit of variability. I said $250 to $350 on the construction costs. There's a lot of variability on revenue. It's real estate at the end of the day. It is a location game. There are jurisdictions where we get $100 a square foot, and there are jurisdictions where we're getting kind of high 20s, low 30s per square foot. But figure $45. I think your average today is probably a little bit higher than that. And then your OpEx is actually quite low. We talked about that service offering, which is very, very tailored, but a campus like the one you see behind me can be managed by five or six people. It's five or six really seasoned people. It's not just anybody who knows how to tow and fuel aircraft, but it's not an FBO that really requires many dozens of people in order to operate. And because it has transient business, we've got a transient business. So figure about $6 per square foot, per rentable square foot, in OpEx, which includes those people's salaries, it includes our ground rent to the airport, it includes any kind of ongoing equipment cost, all of that comes through at about $6 per rentable square foot. So you're kind of year one stabilized, call it your first stabilized year of NOI, figure $39 to $40 a square foot. That's more or less the economics of the business.

Yeah, okay, great. So the way we fund these campuses is, yes, it's a mix of equity and then about 70% tax-exempt bonds. So let me start with the equity and kind of what the strategy has been to date on that. So the first couple years were really about validating the unit economics of this model. I didn't want to start trying to scale quickly before we really had our ducks in a row, and we're happy we did that. We made big mistakes. We knew we would make big mistakes, we just didn't know which big mistakes we were going to make, and the mistakes have gotten a little bit smaller. So we're now kind of surging ahead. It's become about scale. But we had a pretty significant dilemma in 2021, which was: accept a very large private equity investment, which definitely would have had the virtue of funding the company's development through the first 20, maybe 30 airports, so we would not have to think about equity capital for quite a while, but at the cost of very significant dilution to our existing shareholders and also management control. And the other opportunity, which we ended up doing, was going public, taking in permanent capital now, but a lot less capital.

So we were consciously taking a risk that equity funding might not be available when we wanted it down the road. I'd say we're happy being public, and we really deliberated for a long time. It's a small company at the time, very significant expense, and a lot of management attention that we knew would have to be diverted to being public. But on balance, I think that's been really the right decision. One piece is keeping management control, which I think retrospectively has been really key to our growth. We invented this space, we think we know it better than anybody. While we are making mistakes, we do think we're in the best position to make good decisions over time, and perhaps more importantly, quick decisions. Which is great. The deal that we announced today, I think it'd be unlikely that we'd have gotten that deal done had we been private equity owned. And had we gotten it done, it would have been because we paid a real premium for it. So we're happy with that. Also, we're here long-term. We love this. We're all a bunch of retired military aviators here. We love being in the space. Having that permanent capital is great for that. It aligns our incentives with our team, with the airports, with aircraft owners. People know that we're here to stay, and it's a real commitment. And that's a differentiator here. We can talk about kind of who else is in the industry broadly, but that has been a differentiator. So we live with that risk that you highlighted, that the market's not necessarily going to be there for us when we need it. We've tried to keep up with the maxim that you raise money when you can, not when you need it. So we've always been a little bit ahead of the game, and that's always, it's more art than science. I don't know exactly how right we're getting it, but we've raised successive PIPE deals at successively higher valuations, so that we're always slightly overcapitalized for the projects that we're currently contemplating. So you're definitely keeping a very close eye on cost of capital, and you definitely don't want to be one of these companies that's permanently raising capital. We are funded at this point, and we just closed the most recent PIPE, which puts us way past organic cash flow break-even. So this time next year, the company as a whole will be producing cash, which gives us the opportunity to be very deliberate about how we fund our future development, how much of it is reinvestment of proceeds versus...

Taking in new equity capital really now becomes a function not of need but of timing. Do you want to grow aggressively? In one extreme scenario where you've got perhaps several billion dollars of development in front of you and the markets are there for you, great, raise a bit more capital. There are obviously also competitive questions which I'm sure we'll get to as well that should inform our pacing of our growth. But fundamentally, yes, we do want to grow fast but not at all costs. So having that ability would be a big deal. And then of course there's other scenarios where you have the opportunities in front of you but the markets aren't exactly there.

One of the things that I think is interesting, it's a little bit nuanced, but there aren't really strict performance stipulations in airport ground leases. So that if you need a little bit more time to kind of get your ducks in a row on developing, and we've seen other people take 10, 15 years to do that, that's not what I'm talking about. But if you need a year or two to get the stars to align a little bit better on the financing side, or as of next year be in a position where you just need to wait and generate a little bit more internal cash flow to fund your next development, that's possible. You don't really have a gun to your head on the development side. That doesn't mean we don't want to grow fast, we do, but you do have some measure of control over that. So that's on the equity. Anything else you want to ask about the equity?

Right. So our original financing of this business, we were actually taking debt from a hedge fund, which could be precarious, especially when you don't know exactly how things are going to shake out in the business in the short term. I became aware of private activity bonds in the course of that kind of deliberation in the early years and actually very aggressively pursued the gentleman who's now our CFO, Frisco Gonzalez, who is kind of known as the guru or the rabbi of private activity bonds at Goldman Sachs for 25 years. He had actually spun himself out to a hedge fund after that but was very curious about our business, and in our conversations made me aware of something called the ports exemption.

By the way, just conceptually, a private activity bond on a titular basis is actually a municipally issued bond. It is a government issued bond, but the de facto beneficiary of the proceeds of that issuance can be a for-profit company if you comply with certain criteria. And there is one large carve-out which gives you actually a lot of operating room, which is called the ports exemption. Where if you develop on maritime ports and airports, as long as you are compliant with a pretty long list of stipulations, but it's static, you can configure yourself to comply with those. You don't have to wait for any sort of government approval for an issuance of those bonds.

So this was a bit of a risk to see that we could actually do this. And again, we didn't exactly have the equity to back those, the first issuance of bonds when they came up. We felt we could get it, but we weren't in that position. And 2021, 2022 was really kind of a critical breakout year for us in terms of financing because we went public and we issued our first issuance of private activity bonds underwritten by Goldman Sachs.

And those are extremely, it's really a powerful tool because first of all it's a very benign bond market with all sorts of really nice features that you don't necessarily get with other forms of debt. For example, the debt is fully assumable. If we choose to exit this business at some point, the debt goes with it. And it's super attractive debt, which is why I kind of tell people if you're kind of projecting what NOI from a real estate portfolio will look like and then attaching a cap rate to it, maybe discounting from whatever year you do that in today, you might be missing part of the value of this company in that you've got this debt in place.

We're paying about 4.18% fixed for over 30 years on the debt. If we issued today we'd be issuing higher but not much higher. It's really quite an exciting market. And you're doing that against an NOI stream which, again I don't want to overstate it, but looks like a very steeply growing annuity. You've got people, Fortune 500 companies, you have very wealthy individuals, these are very high credit tenants on long-term leases with very sharp escalators. Our leases escalate at CPI with a floor of either 3% or 4% depending on the situation.

Perhaps more excitingly is when we do get a vacancy, we've had maybe not quite 10 of those yet in the company's history, but the average increase from the first term to the second term of the lease is 28%. So again, airport inflation is I think not something to be underestimated in this industry. So if you can attach a nicely growing annuity stream to fixed rate debt and just watch that spread grow year after year, it's super compelling. And so that's really kind of been an afterburner for this business.