DEA - Easterly Government Properties: Viewed Neutrally Despite Positive Developments

2023-08-22 03:43:33 ET

Summary

• A more positive outlook in the transactional market enabled Easterly Government Properties to put out an upward revision in their full-year guidance.
• The newly revised guidance includes up to +$50M in acquisitions for the remainder of the year.
• Though a positive, investors may find it best to wait until there are signs of successful execution in the strategy.
• Until then, shares are viewed best left on hold due to weak earnings growth and poor dividend coverage.

Easterly Government Properties ( DEA ) improved their debt structure through the paydown of their revolving credit facility. An expected thaw in the transactional markets also enabled positive revisions to full-year guidance. And since a prior update on the stock, shares have traded down to a more attractive valuation.

Despite the positive developments, I still maintain a neutral view on the stock due to a combination of uncertain growth prospects, weak earnings growth, and the still-elevated threat of an eventual dividend cut.

DEA Key Stock Metrics

At the end of Q2, DEA owned 86 properties either wholly or through joint venture (“JV”). At period end, the portfolio remained about 98% leased. And all but one of these properties were leased to the United States Government ("USG") with a total weighted average remaining lease term (“WALT”) of 10.3 years.

DEA Q2 Results

In Q2 , total rental revenues were down +$3.4M or 4.8% YOY due primarily to a lower total property count than in the same period last year. The losses were offset in part by the contributions of one new property holding, as well as by the full year effect of two properties that were acquired during Q2 of last year. The lower rental revenues weighed on overall total revenues, which was down +$1.4M during the period.

Total expenses were up by the same amount, led higher by a combined +$3.2M increase in property level expenses and corporate G&A costs. It should be noted, however, that the increase in property level expenses were driven to a large extent by reimbursable projects. And the cost recovery on those projects would have been reflected within the tenant reimbursements line item.

Taken together, with adjustments, cash net operating income (“NOI”) came in at +$46.2M for the quarter. This compares to +$49.2M in the same period last year. On a forward basis stacked against their total enterprise value of +$2.7M at period end, shares traded at an implied capitalization (“cap”) rate of 6.7% at the end of Q2.

On an overall basis, DEA reported core funds from operations (“FFO”) of $0.29/share, down from $0.33/share in the same period last year due to both higher interest expenses and weaker property level performance.

How DEA Plans To Increase Total Revenues

DEA is currently down several properties from recent dispositions. And until now, transactional markets have been muted due to the disparity in bid/ask spreads between buyers and sellers. In the Q2 conference call , however, DEA Chairman, Darrell Crate, reported positive developments relating to seller expectations in the current rate environment.

Accordingly, DEA revised their full year guidance to incorporate up to +$50M in wholly owned acquisitions. This contributed to a positive revision of $0.01/share to the low end of their full-year core FFO expectations. 2023 core FFO is now expected to be $1.14/share at the midpoint, up slightly from $1.135/share previously.

For the acquisitions, it appears DEA will be targeting properties leased to state and local governments. This would serve as a healthy complement to their federal holdings. It could also insulate them from budget/political-related volatility at the federal level. The pivot is also timely, given the recent debt downgrade at the federal level.

Does DEA Have The Financial Capacity To Meet Their Acquisition Target?

In addition to current year acquisitions, DEA is expecting the pipeline to grow further into 2024. And by estimates provided by CEO, William Trimble, they believe +$200M to +$300M in acquisitions could drive FFO growth of between 2% and 3%. This would be a positive, provided DEA doesn’t overextend from a leverage standpoint.

DEA does have their ATM program, which is expected to provide net proceeds of just under +$37M upon settlement. This should provide most of the funds to cover their near-term acquisition goals. DEA also fully repaid the outstanding balance on their credit facility subsequent to quarter end. They now have access to the full +$450M available on the revolver.

Their overall debt load, however, does limit their flexibility. While leverage is at the midpoint of their target zone, I still view it as high at 7.1x EBITDA. Taking on an additional load, therefore, doesn’t seem practical. In one positive, all debt outstanding is at fixed rates, with a weighted average interest rate of 3.8%. But this is offset by their near-term maturity in 2024 on debt which carries a lower rate of interest. Refinancing/interest rate risk, therefore, is viewed as elevated.

Is DEA’s Dividend Safe?

I view DEA’s dividend payout with skepticism. At current trading levels, the annualized payout yields just shy of 8%. Yields on comparatively risk-free alternatives, such as high-yield savings accounts and Treasurys, are offering about 5%.

The 3% spread over the risk-frees doesn’t instill much excitement in me, especially given the heightened risk of a cut. On quarterly core FFO of $0.29/share, the payout ratio stands at over 90%. And this is before considering FFO from an adjusted perspective. Looking at cash available, DEA had just $0.23/share in Q2 to cover a $0.265/share quarterly dividend.

Additional acquisitions could support the topline. And if DEA can meet their growth targets for core FFO, coverage levels could become more in-line. But until those goals are realized, I would view the sustainability of the dividend with caution.

Is DEA Stock A Buy, Sell, Or Hold?

DEA is trading near their 52-week lows and at a more attractive valuation than at the time of my prior update following Q1 results. But this still doesn’t warrant a “buy” rating on the stock.

Shares were recently downgraded by analysts at RBC Capital Markets. And overall consensus Wall Street targets see less than 10% upside potential in the stock. This level of bearish sentiment at the institutional level will likely anchor the stock at current trading levels until there are clearer signs of a reversal.

Successful execution of their acquisition strategy and the resulting improvement in their growth prospects is one catalyst that could produce a reversal in sentiment. The topline boost from the additional properties could also boost dividend coverage, though I’m less optimistic on this due to their higher expense burden.

In the niche space of leasing to government-backed agencies, investors may find Postal Realty Trust ( PSTL ) a better buy in terms of the dividend prospects. And for share price upside potential, I view Corporate Office Properties ( OFC ) as the name most worth holding on this front. At 10.5x forward FFO, OFC trades at a full turn lower than DEA. OFC’s properties are also of better quality, in my view.

With these considerations in mind, I would find it hard-pressed to allocate scarce funds to DEA at this time. For investors continuing to watch DEA, observers should keep an eye on how the company is progressing in their acquisition goals. Until there are signs of further progress here, I would continue to view shares best left on hold.

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