This week, the spotlight shines on a rather distinctive niche within the real estate investment trust (REIT) sector. The subject is Prison REITs, and our jailhouse rocker is Ryan Meliker, a senior research analyst at the New York-based investment bank MLV & Co.
Q: For those who are not familiar with this sector, what are Prison REITs?
Ryan Meliker: The Prison REITs are Owner/Developer/Operators of prison facilities. These companies seek and execute contracts with Federal, State, and Local governments to build, acquire, and/or operate prisons. In addition to traditional prison assets, some companies often enter into alternative corrections operations, including electronic monitoring, daily reporting centers, half-way houses, and youth facilities.
Q: From an investor perspective, why is a Prison REIT considered to be a good place to put your money?
Ryan Meliker: As with any investment, the best place to put your money is an opportunity that offers an attractive risk/reward profile. For starters, dividend yields in the Prison REIT sector are well above the REIT-peer average and are well covered by operating cash flows.
All contracts are with government entities with virtually no risk of default. Issues may arise when certain facilities are up for renewal, but the private prisons have demonstrated their ability to retrain contracts as renewal rates for the sector are in the mid-to-high 90th percentile.
From a growth perspective, while internal growth (rate/occupancy) is somewhat limited and predetermined by government contracts, we see a strong external growth opportunity for the sector as a whole. As of 2013, the private prison industry only accounted for 8.4% of the total prison market share.
We believe there are many benefits to the privatization of the industry, including more efficiently designed facilities, lower operating costs, and offering the government less capital commitment for new development. Furthermore, with capacity and humane issues at the forefront of prison reform, we believe the prison REITs are better equipped to address said issues, which should augment the industries external growth capabilities.
Q: You have been focused on a company within this sector called GEO Group. What role does this company play in the sector, and why should we be paying extra attention to them?
Ryan Meliker: With specific regard to GEO, there are a variety of factors that make the company a very attractive investment. Since December 2007, the stock has generated a 114% total return vs. the SNL US Equity REIT index’s 91%. GEO also has a fairly unique business model featuring alternative corrections solutions which includes electronic monitoring, daily reporting centers, half-way houses, and a couple of youth facilities.
We believe this diversified business model reduces the company’s exposure to regulatory risk, but also offers an eclectic mix of cash flows in an industry that is otherwise fairly static. Most recently, the company also beat out several competitors in an intense bidding process for an Immigrations and Customs Enforcement contract which we view as particularly telling with regard to the company’s negotiating ability and general portfolio quality.
In addition to this, external growth has been rampant as of late, with the company announcing several new contracts and renewals with the government. Finally, GEO also offers a peer-leading dividend at present.
Q: There has been a lot of talk about sentencing reform, on both a federal and state level. If these reforms go through, what will that do to the Prison REIT sector?
Ryan Meliker: We believe investors overestimate the impact of regulatory reform in general. The primary deterrent investors have regarding GEO is this potential impact with sentencing reform, but we believe it would be more headline risk than a detriment to operations. We once again reiterate that GEO in particular has a well-diversified model if such malevolent conditions arise – however, we do not believe this is the case.
Perhaps the best way to explain this is through historical example. California addressed the issue of overcapacity and elevated incarceration rates in 2011 with the California Public Safety Realignment Act. This essentially changed how the state government dealt with lower level felonies, and also moved a large proportion of certain felony offenders into county jails from their previous state prisons.
This resulted in the deactivation of three GEO in-state facilities and one out-of-state facility. GEO was able to manage solid financial performance over this time period, but since then, the company has also re-commissioned all of the properties that went down due to the realignment. We believe this means two things: 1) overcapacity is a serious issue across many states that can’t be simply solved by sentencing reform, and 2) even if sentencing reform is enacted, the quality and management of private-prison properties is, in our view, superior to those publicly-owned.
As the private Prison REITs continue to demonstrate solid financial performance and perpetuate high renewal levels, we believe the Street will continue to become more constructive on the sector as a whole. Additionally, we believe any sentencing reform is likely to bolster demand for non-residential incarceration services. This side of the industry is where GEO is the market-share leader, a dynamic that actually could result in sentencing reform being a net positive for GEO.
MLV & Co. is online at http://www.mlvco.com/.