Easterly Government Properties: Great Tenant, Some Portfolio Questions

Easterly Government Properties (NYSE:DEA) is quite a specialized REIT in the sense that it is focused on real estate which is leased out to the US government, and/or Federal Agencies. The company targets larger buildings which are mission-critical and have a security component in order to create a competitive advantage and increase the chances that its tenant will prolong after typically longer initial lease terms. Other qualities to improve the chance of lease prolongation include the focus on new buildings and those with higher environmental standards, often located at strategic sites.

The Portfolio

Through the end of the third quarter of 2022, Easterly held a portfolio comprised of 86 properties totaling 8.7 million square feet, about 100,000 square feet on average. These are more than 99% leased, with average lease contracts in excess of 10 years and average rents of nearly $35 per square feet. The vast majority of these assets involve office assets, responsible for two-thirds of the portfolio, as well as labs, courthouses, VA Outpatient (Veterans Affairs), and others.

The REIT has only gone public early in 2018, with shares immediately trading around the $20 mark. Shares rallied to the $30 mark in a flight to safety during the pandemic to trade around $20 for the remainder of 2020 and 2021. Rising interest rates meant that shares have come under a lot of pressure in 2022, having fallen to $14 at the moment of writing.

Some Valuation Thoughts

In February, the company posted its 2021 results, as they are a bit hard to read into. The company reported $2.8 billion in assets, of which the vast majority are real estate assets, of course, funded roughly equally with $1.4 billion by equity and debt, of which regular financial debt stood around $1.2 billion.

The company reported $275 million in rental revenues but the expenses of this REIT are quite high. Besides $91 million in depreciation expenses, the company paid $57 million in property operating expenses, $30 million in real estate taxes, and $24 million in operating overhead. After interest expenses, GAAP earnings only came in at $30 million, or $0.35 per share, based on nearly 85 million shares outstanding.

Funds from operations (adjusted) rose to $118 million, equal to $1.24 per share, a number set to rise to $1.34-$1.36 per share in 2022. The company is aggressive in its payout ratio, paying out $1.06 per share in dividends per annum.

The company has been quite aggressive in deploying capital this year. The company kept buying properties under its purchase of 10 Veteran Affairs buildings during the first half of the year, announcing a share buyback program and announcing regular asset deals as well. While announcing a buyback program early in May, the company actually sold shares in the first quarter to finance this growth, having issued quite a few shares at $21 and change. Amidst this dilution, the company posted flat GAAP earnings at 8 cents and flattish funds from operations at $0.31 per share. Similar trends were seen in the second quarter, as the company kept investing more money.

Trying To Create Value

With Easterly having a relatively high initial yield, defined as gross rent in relation to the valued asset base of properties, there is quite some leakage in the portfolio as well in terms of costs. When the company posted third quarter results in November, it announced a big divestment as well. While funds from operations rose a penny to $0.32 per share, GAAP earnings fell to just a penny, predominantly on the back of higher interest expenses and depreciation charges, as the company cut the midpoint of the FFO ratio to $1.27 per share, but that is largely due to a disposition of some lesser quality assets.

The company has reached a deal to sell a portfolio of 10 properties in a $205 million deal. The deal involves shedding a total of 668,000 square feet at a little over $300 per square feet, as these are typically smaller properties as the deal closed just a few days before year-end. The $205 million deal is substantial in relation to a balance sheet which approached $3.0 billion by the end of the third quarter, yet the equity position of $1.4 billion has gradually been coming in below the 50% mark following growth this year and no earnings to show for.

And Now?

The deal makes sense as the quality of the portfolio (in terms of rent, average size, positioning, and WALT) keeps increasing, yet the company is facing an uphill battle. A $1.06 per share dividend supports a huge 7.5% dividend yield at $14 per share, yet there is no real organic growth to show for as the balance sheet is not growing in terms of size, or health with no retained earnings to show for.

The gross initial yield of the portfolio is high, but the cost of operating these properties is huge, even accounting before the dividend. Hence, investors are not happy with the shares, as they are down to $14, trading around book value as interest expenses are increasing with debt rolling off and expense growth of the portfolio outpacing topline rent growth. This comes as not all contracts have rent escalators tied to inflation in them, a potential tough combination. Hence, a great deal of the value has to come from extending leases at higher rates in the future.

Given all of this, there are many moving parts. A 7.5% dividend yield looks nice, but feels too high, and it is not showing any growth, with risks being apparent to the downside. The issue is more that of the underlying operations, a fat gross yield, long-duration assets, and the government as primary tenant should be great, yet lack of inflation escalators and high expenses related to these properties kill most of the appeal.

Nonetheless, it feels as if there might be opportunities here with leverage not apparently a huge issue, certainly not after the recent $205 million disposition, yet focus should really be on improved execution to unleash more potential, despite the overall overhang of higher interest rates.

Improved focus, excellence and focus on higher net leases should drive operational excellence, as a small position might be warranted, although I lack conviction to buy more due to the perceived underperformance on the operational front.