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The Price of Converting to REITs

Many listed property companies are converting or considering converting to real estate investment trusts (REITs) in South Africa since the April 1st new tax regime for list REITs was enacted. Other countries have gone down this road and one may ask as to how their share prices fared as a result of such action.

 

U.S.-listed real-estate investment trusts, or REITs, are on track to issue more new equity in the U.S. than in any year since 2001, according to Ipreo, a capital-markets data and advisory firm. REITs have raised $16.8 billion in U.S. IPOs and secondary stock sales so far in 2013, a pace that would top 2012’s record $36.6 billion.

 

During the last couple of years, REITs, aided by investors’ rabid appetite for income-producing investments, consistently have trumped the broad market. In 2011, while the S&P 500 was flat, the FTSE Nareit U.S. index jumped 4.3%. Last year the S&P was up 3.8%; the REIT index, 5.9%. No wonder, then, that companies in industries including digital-transmission towers, data warehouses, private prisons, and health-care facilities are seeking to convert to REIT status. And there are attractive opportunities to play this trend through the shares of companies likely to undergo a conversion.

 

In the US, for example, and much of the world follows the lead, a company seeking to become a REIT must satisfy two main criteria: It must derive at least 75% of its revenue from rents and other direct real-estate activities, and it must pay out at least 90% of its profits to shareholders as dividends. In return, those profits are untaxed at the company level, and the hope is that yield-focused investors will flock to the shares.

 

One of the most prominent conversions last year was American Tower, the leading owner of mobile-communication transmission towers, which moved to become a REIT soon after it had used up its tax-loss assets. The switch, effective last Dec. 31, immediately made American Tower the second-biggest publicly traded REIT. Its current market value is $26 billion. The stock gained 14.7% in 2011’s second half, after it started the conversion process, and last year added another 8%.

 

Now, American Tower’s smaller rival, SBA Communications (SBAC), is setting the stage for a conversion, already reporting adjusted funds from operations, or AFFO, as REITs do, alongside its usual operating-company results.

 

According to REIT commentators Online Barrons, Jeff Kolitch, portfolio manager at the Baron Real Estate Fund (BREFX), says that the average REIT fetches 22 times AFFO, a measure comparable to operating cash flow. At a recent price of around $50, SBA was trading at about 17 times this year’s forecast operating cash flow. At 22 times, the stock would be around $66.

 

Datacentre REITs are currently performing well and are popular among investors who are attracted by their high dividend pay-outs as well as by growing demand for datacentre real estate. The strength of the sector could push other datacentre companies to go public or adopt the REIT format. One example of this is Equinox, a company operating datacentres for the likes of AT&T and Amazon.

 

The following three datacentre REITs are good examples of REIT switching success stories;

 

• CoreSite Realty (COR), with market capitalization of $580 million, is most similar to CONE. COR is the smallest datacentre REIT, but its stock value has increased 33% since the end of October, and its dividend yield measures 3.6%.

 

• Digital Realty Trust (DLR) is the largest of the three data centre REITs with market capitalization of about $8.4 billion. Its stock value increased more than 16% since the end of October, and its dividend yield is 4.1%.

 

• DuPont Fabros Technology (DFT), with market capitalization of $1.5 billion, is the second largest data centre REIT. Its stock value grew 14.8% since the end of October, and its dividend yield measures 3.3%.

 

Finally Corrections Corp. of America converted to a REIT and is the nation’s largest operator of private prisons. The company operates 66 correctional and detention facilities, and has a total capacity of about 91,000 beds, yes, that’s real estate, in 20 states.

 

Correction Corp.’s funds from operations (FFO) per share, a key REIT cash flow metric, grew 7% to $2.34 in 2012 from $2.19 a year earlier. Corrections Corp. has provided guidance for a 16% rise in 2013 FFO per share to between $2.72 and $2.87. Some of this growth will likely come from a one-time tax benefit of between $115 million and $135 million from converting to a REIT. Corrections Corp. plans to pay quarterly dividends at an annualized per-share rate of $2.04 to $2.16 this year. At the mid-point of this range, shares yield almost 2%. In addition, the company will pay a special one-time dividend of at least $650 million to investors during 2013. The special dividend will be a combination of cash and stock.

 

The lofty valuations that REITs now command in the US might not be sustainable over the longer term, especially if interest rates rise, offering good alternative income investments. And the requirement that 90% of earnings be paid out to shareholders means earnings can’t be accumulated for future investment, necessitating that still-growing REITs sell equity or debt to buy or build additional properties. REIT conversions could boomerang down the road. But at the moment, the haste to be a part of the REIT club holds rewards for discerning investors.

Private Prison REITs Released

xlarge_chinopenPrivate prisons are big business and two big players with facilities in South Africa, US, Australia and the UK have just undergone REIT conversions. Corrections Corporation of America (CXW) and GEO Group (GEO) each received favourable Private Letter Rulings from the IRS and began operating under REIT rules.

By reducing their corporate tax liability, improving their access to capital and lowering the cost of capital the REIT structure provides more opportunities for these companies which are capital intensive by nature.

South Africa

thumbTo zoom in on a South African example: MMSP( Mangaung Maximum Security Private Prison),was the first of two South African Private Prisons and  the brainchild of the first Post-Apartheid Minister of Correctional Services, Dr. Sipo Mzimela, who, upon taking office in 1996, was appalled by South African Prison conditions, up to 300% overcrowded, and a seething hotbed of corruption.   In such conditions reformation is impossible. The GEO Group promised and by all reports delivered, more humane conditions.

The South African government signed two 25-year concessions for maximum security prisons in Bloemfontein and Louis Trichardt (Makhado) as part of its Department of Public Works’ Asset Procurement and Operating Partnership Systems (APOPS) in 2000. The two winning consortia were responsible for designing, building, financing, operating and transferring the prisons. The facilities hold about 3,000 inmates each and were fully operational in 2002 at a cost of about $245 million (Bloemfontein) and $259 million (Louis Trichardt), respectively. The Geo Group now manage these.

The prison gets 60% of its revenue from company-owned or leased real estate.

The Geo Group is the second largest of the two big players in the US. It has a current market capitalization of $2.5 billion and/or manages 100 correctional, detention, and community re-entry centres with 73,000 beds across the US, Australia, South Africa, and the UK. (The prison gets 60% of its revenue from company-owned or leased real estate.) The company estimates $45 to $50 million in annual tax savings from its REIT conversion. In January, GEO raised its quarterly dividend from $0.20 in 2012 to $0.50 a share, resulting in an implied yield of 5.6%. Shares of GEO have more than doubled (+105%) during the past twelve months.

Biggest Operator

imagesThe bigger name on the block is  one of the largest prison operators in the United States. CXW’s current market capitalization is $3.8 billion. The company operates 67 facilities and owns or controls 51 facilities in 20 states with a total capacity of about 92,500 beds. CXW’s REIT conversion greatly reduced corporate tax obligations. The company increased its quarterly dividend from $0.20 in 2012 to $0.53 after the conversion, resulting in a 5.5% implied dividend yield. Shares of CXW climbed 47% between March 2012 and March 2013, at least in part due to the REIT conversion.

No Shortage of Prisoners

Private prison facilities have increased their percentage of all prisoners growing steadily over the past few years, increasing from 7.9% in 2010 to 8.2% in 2011. Currently 10% per cent of total prison capacity in the US is operated under contract with private companies such as CXW and GEO. The remaining 90% of total prison capacity is operated by state and federal government. In light of government budget constraints, both federal and state governments have increasingly turned to private prisons. With only a few companies in the private sector and high barriers to entry, private prisons face limited competition.

Unaffected during a recession

The private prison industry is largely unaffected during a recession. States/countries may release some prisoners early to control costs, but overcrowding means demand is unlikely to fall significantly. According to a 2008 study by the Pew Centre, the US incarcerates more of its citizens than any other country and people are staying in prison longer, underscoring strong demand for facilities.

Controversy

2347746278It’s worth noting that some of these facilities are controversial because their profit motive encourages incarceration. In contracts to operate state prisons, CXW requested a minimum guaranteed occupancy rate of 90%, which did not go over well with many public interest groups. Private prisons achieve profit margins by controlling costs and spending less for personnel than their public counterparts, which raises the issue of the quality of staffing at these privately-run facilities. By way of example CXW now faces a staffing scandal in its Boise, Idaho, facility where 4,800 hours of supposed work time were falsified. That’s a direct violation of its contract with the state, and an internal and external investigation is underway. We’ll see how it plays out.

REIT conversion for CXW and Geo Group has unequivocally improved their financial positions and contribute to sharp growth in their stock values during the past year. Although prisons are relatively immune to the negative impacts of a recession, inmate populations generally accelerate when economic growth resumes and governments have more to spend on incarcerations. With the recession behind us, demand for these REITs should improve.