REITs Go to Prison

This article is republished with permission from REITCafe.

Like all real estate investment trusts (REITs), prison REITs have been beaten down this year by the prospect of higher interest rates, but they have been further affected by discussion of prison reform and new government regulations. In spite of healthy revenue growth and earnings that have surpassed consensus estimates, Corrections Corporation of America (CXW), which has a market capitalization of about $3.8 billion, is down 7.8 percent in 2015, while Geo Group (GEO), with a market cap of $2.5 billion, is down 10.9 percent. Is now a time to buy?

Prison REITs are dependent on government spending, which is both a positive and a negative for them. Their primary tenants, whether the federal or state governments, have high credit quality. Prison REITs have increased their diversification by operating a range of different types of facilities, from state prisons to federal immigration detention facilities, and GEO has further diversified through international investments in the United Kingdom, Australia, and South Africa.

However, the REITs are also at the mercy of budget cycles and politics. In its second-quarter earnings call, CXW reported that improving economies mean increased tax collections and fewer budgetary pressures for its tenants. It reported that its state partners have completed their budget approval process for fiscal year 2016 and that all of its contracts were fully funded. Strengthening economies also improve CXW’s ability to receive contract pricing escalators.

Reform initiatives are an ever-present concern for prison REITs. In July, President Obama visited a federal prison and called for prison reform, including reducing sentences for nonviolent drug offenders.

REITs could be affected by a federal court case related to the length of stay at family residential centers. In the second quarter of 2015, CXW completed construction on the 2,400-bed South Texas Family Residential Center. At GEO’s Karnes ICE Residential Center, which also provides family residential housing, a 626-bed expansion that is slated for completion in the fourth quarter will bring the center’s capacity to 1,158 beds. The REITs are protected by contracts related to these facilities. Still, the court case increases uncertainty related to facility use.

REITs have also been affected as the state of California takes measures to comply with a 2013 court order to reduce prison overcrowding. The state is undergoing a realignment to eliminate overcrowding of state prisons by turning over nonviolent offenders to counties, which in turn is leading to a boom in local jail construction. The passage of California’s Proposition 47 in 2014 also makes felony drug possession a misdemeanor, which has helped reduce inmate populations.

As part of its inmate reduction plan, California decreased its out-of-state inmate program by 500 during April, and it expects an additional reduction of 2,000 or 2,500 inmates through the end of 2015, as well as a further reduction of 1,300 by June 30, 2016, which will bring its out-of-state prison population to about 5,000. CXW noted that the reductions are occurring more rapidly than it had expected but that they are in line with its expectations. With its California contract set to expire in June 2016, the terms of a multiyear extension have not yet been finalized.

Prison REITs are subject to local, state, and federal politics, but long-term projections indicate that inmate populations will expand in spite of reforms. Existing prison stock has aged, and federal and state governments have little appetite to invest in upgrading existing or developing new facilities. With strong dividend yields in the 6 to 7 percent range and pipelines of new construction that will drive revenue growth, these REITs are attractive but risky.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.

** - 10 yr. Treasury Yield as of 08/17/2015.