Real estate investment trusts (REITs) have delivered strong gains recently as investors have been attracted to income producing assets while interest rates remain pegged near zero. Furthermore, many companies have joined the rush by applying for REIT status, although the IRS has become more scrupulous of this practice. Here, we’ll review four companies that have successfully or unsuccessfully made the switch and highlight the one which appears to be the best investment now.
How REITs work
In order to convert to a REIT, an applicant must satisfy two criteria: it must derive 75% of revenue from rent or real-estate investment income, and it must pay 90% of profits to shareholders as dividends. In return the company receives generous tax incentives and a lower cost of debt because REITs are considered to have lower credit risk. Thus, the converting company gets a double boost in efficiency increasing its earning power.
American Tower Corp (NYSE:AMT)
is one of the largest REIT conversions in the past several years. The company converted to REIT status in December 2011 and earned a return of 16.92% in 2011 and 33.09% in 2012, substantially outperforming the S&P 500 before and after
the REIT conversion was publically known. Furthermore, American Tower Corp (NYSE:AMT) already traded at a premium valuation of over 50 times trailing earnings at the end of 2011, but as profitability expanded the stock price appreciated.
One less successful attempt to convert to REIT status was undertaken by Iron Mountain Incorporated (NYSE:IRM)
and its share price was pummeled as a result. The IRS has become more scrupulous in verifying applicants to dissuade companies from taking advantage of the tax code. Boston based Iron Mountain Incorporated (NYSE:IRM) is a leader in information protection, providing shredding services, data recovery and storage for its mostly corporate client base. In June of 2012, an application for REIT status caused significant expansion of Iron Mountain Incorporated (NYSE:IRM)'s valuation from 1.7 times trailing revenue in May 2012 to 2.3 times one year later while the share price more than doubled. Due to the IRS inquiry the share price has fallen over 25% and interestingly the price to sales multiple has returned its valuation before the application. This demonstrates how highly the market values REIT status both from how highIron Mountain Incorporated (NYSE:IRM)'s shares flew on news of the application and how far they have fallen since.
Corrections Corp Of America (NYSE:CXW)
is a compelling investment opportunity after their recent conversion to REIT status, which was completed around January. This investment isn’t going to give you a warm and fuzzy feeling; Corrections Corp Of America (NYSE:CXW). operates 67 detention and correctional facilities in over 20 states as well as the District of Columbia. However, if privatized prisons do not appeal to your sensibility, consider the durability of the business model. Given current prison overcrowding space is at a premium, furthermore, state and federal government have become more interested in utilizing the efficiency of the private sector to keep costs under control. The Geo Group, Inc. (NYSE:GEO)
is also a prison operator and gives a good sense of comparison within the industry.
The table below demonstrates just how cheap CCA is relative to the average REIT. The trailing earnings and PEG ratios for GEO and CCA show both stocks are underpriced relative to the S&P 500. The price/sales multiple shows that they both are very cheap relative to the average REIT, although margins are somewhat lower. Furthermore, both companies have significantly greater expected future growth and past growth compared to the average REIT, with CCA having superior margins and ROE.
Why further upside may be in store for Corrections Corp Of America (NYSE:CXW)
Further upside should be expected for CCA if the market has not yet fully discounted the increase in profitability that will accompany REIT status. While the stock has risen about 28% in the past twelve months a quick examination of CCA’s income statement reveals how significant the REIT conversion is.