Crime Pays… At Least if You Structure it as a REIT

by Jason Jenkins

A reasonable person might ask why a company whose main purpose is to house prisoners would want to be thought of as a real estate entity. It turns out the answer is quite simple.

Life used to be easy for private prisons.

Gone are the days back in the '80s and '90s when the growth potential of private prisons was off the charts. It was a perfect storm for prisons with an ever-growing inmate population and policy that was friendly to the industry. Back then, private prisons could get subsidies from the government and had access to cheap labor. It was a time when private prisons could regularly reach triple-digit earnings gains.

But don't shed a tear for the industry.

It's true that inmate numbers are on the decrease in some areas and prisons have been shut down… but the party is not over.

Making Crime Pay

One of the reasons the major players in the private prison industry will continue to prosper is that the United States is a society that loves to lock people up. We have the highest incarceration rate of any industrialized nation.

According to 2009 figures from the Bureau of Justice Statistics (BJS), the United States puts 754 per 100,000 people in jail. America represents about 5% of the global population, but its inmate population is a quarter of all those incarcerated around the world.

In other words, the prison industry remains strong. And now the two biggest private prisons are about to become even more attractive.

At the beginning of this year, Corrections Corporation of America (NYSE: CXW) and The GEO Group (NYSE: GEO) announced they finished all preliminary paperwork to convert into Real Estate Investment Trusts (REITs). Combined, the two own 75% of the for-profit prison market in the United States.

In case you're wondering how prisons can become REITs, let's do a quick review of this unique corporate structure:

  • REITs are made for companies that primarily invest in and/or get their revenue from real estate holdings.
  • They get special tax treatment.
  • REITs have to disburse at a minimum 90% of their income to shareholders by way of dividends.

CXW and GEO run prisons. But remember, prisons are also a form of real estate.

This is all possible as long as they split the operational side of prison management from land ownership. They do this by creating something called a "taxable REIT subsidiary" that runs the real estate business.

GEO in the Lead

Shares of GEO have doubled in value over the past year. Its decision to become a REIT makes sense. The prison gets 60% of its revenue from company-owned or leased real estate.

The company controls 109 facilities in the United States, Australia, South Africa, the United Kingdom and Canada. And as I stated earlier, prison populations contracted in many areas. But GEO expanded last year.

It opened new jails in Georgia, Texas and California. The Georgia facility is expected to be worth about $28 million a year. The two new facilities in Texas and California together should account for another $36 million annually. The company also added 512 beds in an Indiana facility. The expansion will boost annual sales by $8 million.

Put all this activity together with the existing business and GEO generated about $1.5 billion in total revenue for last year. That number is up from the $1.4 billion in 2011.

Gross profit in 2012 was better than the year before - going from $371 million to $390 million.

But here's where things get interesting.

The company currently has 6,000 unused beds spread across its facilities around the country. Management has hinted this capacity could be put to use in the near future. With sequestration efforts pinching many state and local budgets, the time could be right for a big move.

Run the numbers above and GEO looks undervalued when you put it head-to-head with its closest peer (CXW). Its growth looks good and its dividend yield is 5.5%. It offers the best of both worlds.

A Note on CXW

CXW is the larger of the two companies. It runs prisons in 20 states and Washington, D.C. It followed GEO into the REIT restructuring process. The company's request to become a REIT was approved on Feb. 1. Almost immediately, the company saw some of the same success GEO witnessed after its transformation.

In March, CXW announced its first dividend as a REIT. It declared a first-quarter dividend of $0.53 per share to be paid April 15.

However, the last few days demand added caution. 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.

Good Investing,


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