Uncle Sam as tenant? Two stocks with government exposure – Part I

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While it is not directly investing in the government per se as you won’t have any direct ownership in it (luckily), I’ve found two stocks that are operating in the name of it. I am not talking about defense companies where governments are the sole customers (individuals don’t buy tanks). There are two high-yielding REITs with several government agencies as their tenants. Are they worth a look? Part one.

Summary and key takeaways from today’s Weekly
– It seems tempting to have the government as a tenant. But this does not guarantee to have a great stock.
– Easterly Government Properties has been a value destroyer in the past.
– It is suffering from too much debt and the stock still is expensive.

Some might laugh about this idea, others might dismiss it outright.

Investing in the government, respectively in entities that are having ties almost exclusively to the government, is a strange idea. I agree. But like companies, governmental agencies also need office space to do their bureaucracy productive work.

Likewise, there also do exist fully state-owned operations with non-governmental, private-sector competitors in mission critical sectors of everyday life.

That’s how I stumbled upon two high-yielding REITs – real estate investment trusts – that only have the government in some form or the other as their tenants.

As many people think that governments never go bankrupt and are the most credit- and trustworthy debtors (I urge you to have a look into history books), the investment thesis might be that rents from the government are as safe as day and night.

The respective stocks are likely in high demand and of high quality, aren’t they?

source: Michael Conway on Pixabay

The first thoughts are tempting – receiving seemingly safe rents through publicly traded and liquid enough stocks that seem to be cheaply valued and at the same time offering high, above-average dividend yields.

Is there something to complain about at all?

Today, I will put Easterly Government Properties (ISIN: US27616P1030, Ticker: DEA) under the microscope to answer these questions.

Is this a no-brainer stock or at least the safest dividend stock you can imagine?

Let’s find out.

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Office space for the government

Easterly Government Properties is a publicly traded company, meaning that the government does not own “its” buildings, but like everyone else is paying rent to the private sector.

As the name suggests, Easterly are renting out office space to several governmental agencies. The two by far largest tenants are the Department of Veteran Affairs (“VA”) with 23% of leased space and even 28% of rent income as well as the Federal Bureau of Investigation (“FBI”) with 17% of leased space (17% of rents).

That’s already 40% of DEA’s leasable space and even 45% of their rental income.

Other tenants are the Drug Enforcement Administration (“DEA” – funnily the same abbreviation like the REIT’s), the U.S. Citizenship and Immigration Services (“USCIS”), the Environmental Protection Agency (“EPA”) or the Food and Drug Administration (“FDA”).

As it is rather unrealistic for these agencies to look too much on efficiencies, budgets or optimizations of workflows, DEA (the REIT) should not be worried about waning demand from its customer(s).

Office space is under heavy pressure in many regions, but there are two exemptions:

  • regarding the government
  • the idea I presented to my members last September (see here)

In the end, the tax-payer government is the one who’s paying the should-be safe rent.

source: DEA – FY 2023 supplemental material, p 22 (see here)

At least regarding 97% of DEA’s leasable space. Just 2.8% is rented by private tenants, as you can see below.

However, I think this does not change the fact that we are talking about a high dependency on pleasure to deal with the government.

source: DEA – FY 2023 supplemental material, p 23 (see here)

This leads me to another point in favor of this type of tenant.

They are unlikely to move out to a competitor once set to save a few pennies on the rent, so you rather don’t have to worry about lengthy negotiations and the danger of having to replace your tenant.

In addition, the lease expiration profile looks impressively favorable.

Honestly, this is a clear point for DEA.

source: DEA – FY 2023 supplemental material, p 24 (see here)

As governments have the tendency to grow and not to shrink, one could assume that this is a growing business, albeit a slow one.

A mix of higher rents and more agencies moving in (acquisition of more buildings) should form a predictable and reliable income stream for the owner, especially factoring in the great duration profile of the signed leases.

As of December 31, 2023, DEA’s portfolio had a weighted average age of only 14.6 years (based upon the date properties were built or renovated-to-suit) and a weighted average remaining lease term of 10.5 years – which is quite high.

As we know, the market hates uncertainty. Here, we are seemingly having exactly the opposite.

Taking all the above into account, one should assume to find a stock with an excessively high valuation multiple as nothing should go wrong.

Now come the but’s.

The stock is trading near its all-time low. Easterly has been a publicly traded company since 2015. As we can see, the peak was in April of 2020.

Instead of a high price to FFO (funds from operations – a REIT’s earnings) multiple, Easterly is trading at a rather depressed and low 9.9x.

source: Seeking Alpha (see here)

Since being a public company, Easterly has increased its revenue from about 60 mn. USD in 2015 to almost 300 mn. USD in 2023. That’s a yearly growth rate of not less than 22.2%.

However, if you look closer, you’ll see that sales have been rather stagnating over the last few years.

And operating cash flow has even been on the decline.

source: TIKR

The issue is massively increased borrowing costs and a not so great balance sheet.

This has not only put a full-stop on the growth story, but even reversed it.

As it seems, the balance sheet was built under the expectation that interest rates will never rise again. The average debt maturity is less than five years with several big blocks coming in over the next years to be refinanced.

Most people don’t talk about cash flows in connection with REITs.

But as cash (flow) is what pays debt and not an illiquid figure like net earnings or EBITDA, I think it is critical to have a closer look.

You can see above that yearly cash flow has been between 100–150 mn. USD in the recent past. The so far not cut dividend (but also not raised since 2021) costs the company currently exactly 100 mn. USD.

This is without any investments in the business (REITs are capital intensive).

Easterly is facing several big debt walls of the equivalent of entire yearly cash flows – or even more – almost every coming year, including 2024.

Refinancing will lead to higher cost of debt, pressuring cash flows even more.

If this is not tight-knit, I don’t know what is.

Btw, this reminds me somewhat of the case of once highly appraised W.P. Carey (ISIN: US92936U1097, Ticker: WPC). I described why it had to cut its dividend as an aristocrat here.

source: DEA – FY 2023 supplemental material, p 17 (see here)

Net debt to EBITDA is a not-low 7.3x and interest expenses will only rise until interest rates are lowered – however, this is a big if and not a given. I do not want to be dependent on that.

So, we can rather assume that the dividend is not that safe.

Maybe this is what the market has been pricing in.

As I wrote in my preceding weekly (see here), sometimes companies that cut their dividends reemerge stronger and such stocks start new runs higher.

However, I have doubts that this will be the case with Easterly.

In the past, they have been a great value destroyer, when you look past the dividend.

And this is the other part of the truth.

Cash flow per share now is where it was in 2015, even a bit lower. I cannot even rule out that due to the coming rounds of expensive refinancing, Easterly’s cash flow will even hit new all-time lows (as a public company). The alternative is to raise fresh equity and dilute shareholders heavily – likewise not a great option.

It is difficult here to see a value-accretive success story.

source: TIKR

REITs frequently use capital raises to not overdo it with debt issuance, respectively to balance them out. This obviously leads to dilution.

But as the stock is now sitting pretty low, new equity has become highly dilutive.

Dividends per share may have remained stable, however, total dividends for all shares have increased over the years.

source: TIKR

Under these circumstances, I would definitely not invest in this REIT.

Thought a step further: assuming a dividend cut comes and the stock craters in reaction to that – what about the valuation?

The market cap is 1.3 bn. USD. Including net debt, we get an enterprise value of about 2.5 bn. USD. That’s a lot compared to operating cash flows of only 100 mn. USD – 25x.

Net asset value – or the tangible book value per share as a proxy – is around 11 USD per share. This is where we are today. So at best, this is fairly valued, but certainly not trading way below asset value.

In essence, despite the more than 50% drop from its highs, I do not see any undervaluation here with this stock. To the contrary. I’d like first to see a dividend cut paired with aggressive deleveraging efforts and a stock price that tanks by at least 20%, maybe even 30%.

No, thank you!

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It seems tempting to have the government as a tenant. But this does not guarantee to have a great stock.

Easterly Government Properties has been a value destroyer in the past.

It is suffering from too much debt and the stock still is expensive.

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