Description

Who wants to go long a defensive 10y US Treasury proxy with an equity while picking up 330 bps of yield ahead of the Fed meeting?

*crickets*

But for equity accounts that seek current yield with a defensive, reasonable yield pickup over Treasuries, Easterly Government Properties (DEA) REIT might fit the bill. DEA is a sleepy, growing, government property REIT that trades off the 10y US Treasury yield. DEA is a modestly attractive opportunity now at a ~4.80% dividend yield, trading at a 30 bp yield discount (vs the 10y UST) relative to historical averages. 

In Short:

• DEA’s 4.80% current yield is close to risk free over the near term as a REIT 100% focused on Federal Agency government properties that have high renewal rates.

• Has the duration of a 10y corporate bond but offers +100bps of yield over HY credit and +330bps over 10y UST. HY Credit indices are yielding 3.88% with a near all-time tight spread of +289 bps.

• DEA common has some modest equity upside from external growth opportunities (+5% YoY asset growth guide) and less duration and call risk relative to REIT perpetual preferred securities trading at a premium and rich valuations.

• Defensive posture (long 10y UST) against any potential turn in broader equity markets and within its sector. Should be a beneficiary of any topping out of the re-opening trade that’s pushed propelled more traditional office REITs. 

The Trade:

Today’s 330bps of yield pickup versus the 10y UST is 30bps wide to its historical median and average of ~300 bps. It’s also near the wider end of its historical range of 200-400 bps, so the spread to 10y UST has some room for potentially tightening if rates do indeed rise in a somewhat orderly fashion. If you find yourself in the camp for lower-for-longer rates with the Fed potentially on hold until 2023, it’s an ok entry point today in my view, unless you wish to wait until after the pending Fed meeting. DEA also has regular ATM issuance to fund growth which may weigh on shares periodically which can weigh on price. DEA most recently raised $40mm in Q1’2021 with 1.556mm shares at $25.69.

If you're looking to hedge rate risk (I'm not), you could subject yourself to widening spread risk by shorting 10y futures against long DEA. 

Obvious PSA - 10y yields matter a lot:

Disregard or back pocket this idea if you think the 10y UST screams up 75bps to 2.25% this year on the back of rising inflation concerns. Personally, I only hold a small position size as due to inflation and yield curve steepening concerns, but DEA can still serve as a good defensive equity market hedge in a portfolio should UST 10y yields crash amid an equity sell-off. DEA drastically outperformed equity indices and other REITs during the COVID sell off from Feb – May 2020 in the flight to quality with the rally in Treasuries. From February to May 2020, DEA returned +5.76% vs. -4.93% for the S&P 500 and -16% for US REITs. 

About DEA:

DEA is a pure-play $3.3bn government REIT that only leases to Federal Agencies with “enduring missions” as part of their “bullseye” strategy. This includes federal agencies that are growing, have priority in Washington, or are security related. The VA, FBI, DEA, Judiciary, FDA, EPA, IRS, and JSC are its largest tenants, accounting for 65% of annualized lease income, making tenant credit risk virtually zero. (larger breakout below) DEA aims to avoid agencies with higher political risk. Political risk will always exist to some extent longer term, but I still don’t expect to see Washington to pursue austerity measures over the next 12 months. DEA has been doing this awhile, and clearly must have a pretty good relationship with agencies and the GSA that administers the leasing process. 

Bullseye & Leasing Strategy

DEA focuses on leasing ‘specialized’ ‘bullseye’ properties to agencies rather than generic office space. DEA reports 87% of its book are these bullseye properties that have some sort of specialized fortification or equipment from tenant improvements or new development (likely overstated, but whatever). These are properties with security fortifications, specialized labs, special technology, etc. 

Specialized properties come with 1) a higher propensity for renewal at lease expiration and 2) have better opportunities for rent growth of 10-15% come renewal time.  The federal government renews specialized properties at an estimate of replacement cost, whereas any rent hikes for vanilla office properties are much harder to come by. 

Growth Prospects:

DEA ended 2020 with $3.3 billion of gross assets and targets asset growth of $200mm a year. DEA acquired $250mm of assets in 2020 and $80mm of properties YTD through June 2021. The company targets 2-3% annual FFO growth, so a 7% total return opportunity over the long haul adding in the dividend if you're not trying to trade the spread or rates. “The company is maintaining its previously issued 2021 FFO per share on a fully diluted basis guidance in a range of $1.28 to $1.30. The midpoint of this guidance is predicated upon completing $200 million in acquisitions and $25 million in growth development related investment in 2021.”

Edge & Market Dynamics

Easterly claims to have some barriers to entry due to its long track record and knowledge around the Government Services Agency’s (GSA) glacial, bureaucratic procurement process. Whether this is true going forward in an environment flush with low vol capital to put to work, I guess we’ll see. Market dynamics do seem favorable for DEA as the GSA’s inventory has favored leasing versus owned real estate over the last 20 years. GSA Leased inventory has grown 23% since 1998 while owned-inventory has been flat. 

Properties & Leases

DEA’s book:

• 8.7 year weighted average lease term (WALT)

• 6.1 year weighted average debt maturities

• Properties are 13.3 years old on weighted avg basis 

• New leases are struck at 10y+

Leases:

• 10.1% of lease expirations remain in 2021-2022 – in active discussions with GSA - I'd expect these to be renewed

• YTD 2021 4 properties renewed at an 18 year WALT, representing 3.1% of lease income – properties released at an average of 8.5% cash leasing spreads

Relative Value

Fundamentally, DEA is admittedly rich for a reason relative to office REIT comps given its pure-play nature. There is no other pure-play government REIT. In 2018 GOV merged with SIR to form OPI, which today is 43% government. OPI remains clearly much lower quality.

That said, a small size and ‘low growth’ discount remains when looking at DEA relative to other REIT sub sectors, so I don’t think valuation today is too aggressive if you buy into the 5% YoY asset growth objectives over the next 10y. 

Bottom Line: DEA is trading somewhat cheap to historical levels and offers a 4.80% dividend yield, which is sadly good today for equity portfolios that need current yield. You won't be hitting a homerun, but the name can benefit a portfolio given its flight to quality and defensive characteristics. 

Rates Sensitivity / Scenarios

Share price sensitivity to the 10y US Treasury Yield and Spread -- box highlights where we are today

Horizon return scenarios for 12mo  (Principal chg + divvy income)

Appendix 

• 2020 10-k https://www.sec.gov/Archives/edgar/data/0001622194/000156459021008064/dea-10k_20201231.htm 
• Investor Presentation June 8 2021 : http://s23.q4cdn.com/455376602/files/doc_presentations/2021/06/210608-Q1-2021-Investor-Presentation_Nareit-(final).pdf 

~Breakout by lease type as % of rental income:

OC Outpatient Clinic   14.5

O Office                     64.4

L Laboratory              13.4

C Courthouse             4.8

W Warehouse             2.7

D Distribution             0.0

M Manufacturing         0.2

~breakout by agency (90% of annual income) as % of rental income

VA     17.7

FBI    16.7

DEA   10.1

JUD   4.9

FDA   4.7

EPA   4

IRS   3.5

JSC   3.3

ICE   3.1

BFS   2.8

CIS   2.8

FAA   2.6

PTO   2.5

SFS   2.4

SSA   2.2

EMA   1.9

CBP   1.5

DOT   1.5

SHA   1.2

DHA   0.9

COVID performance

DEA vs. UST 10y Time Series charts - Yield, Spread, Dividend

Catalyst

Positive Catalysts: Falling 10y US Treasury Yields, lower for longer rate environment, slowdown in the re-opening trade for other Office REITs, broader equity market sell off, continuation of tight spread environment across credit

Negative catalysts: The opposite. Rising rates, steeper yield curve, rising competitive environment for deals given flush private and public capital on sidelines. Max pain comes with an equity sell-off amid rapidly rising rates that causes spread widening. But atleast you own quality in that scenario.