Easterly Government Properties: An Inflation Hedge Against Recession (NYSE:DEA)
The yield curve is doing what it does best: forecast recession. The 10Y treasury yield minus the 2Y yield is now at 0.330 after dropping 124 basis points in a year. With the Fed set to raise rates this month and implement quantitative tightening it is beginning to look certain that a negative yield curve will signal in the next few months.
To compound the issue, the price of oil is rising fast. It breached $100 a barrel and reached $115 three days later. Clearly, the conflict in Ukraine is contributing to the issue but the trend was intact prior to the war. As you can see from the chart below every time oil surges higher and the yield curve turns negative a recession occurs shortly thereafter.
Normally, I would be seeking to increase the bond positions of my fixed income allocation in preparation. However, elevated inflation rates are impacting the suitability of bonds, resulting in widespread negative real yields and increased rate risk.
Therefore, I’m considering more inflation-protected forms of stable income. Gold has inflation protection but no yield. TIPS bonds have inflation protection but trade at negative yields. This is where a security like Easterly Government Properties, Inc. (DEA) comes in handy.
Inflation-Protected Bond Substitute
Easterly Government Properties is a REIT that invests primarily in government-leased properties. Agencies of the U.S. government account for 97.5% of the company’s lease income, creating a portfolio with impeccable protection from rent delinquency because the leases are backed by the full faith and credit of the U.S. Government.
While many REIT tenants have questionable ability to meet rent obligations in the face of rising inflation and recession, government tenants have superior tenacity to endure and meet their obligation. This is why the U.S. government has not experienced a financial default. Lease renewal rates with government agencies is high and when leases are renegotiated factors including inflation are amicably considered. At the end of 2021 the company achieved a 99% occupancy rate.
The following chart compares the performance of DEA with gold (GLD) and TIPS bonds (TIP) over the last 6 years. We can see that DEA is correlated with these stable inflation-protected assets but tends to outperform. Curiously, after a brief pullback the stock price actually spiked up during the 2020 COVID recession. This demonstrates the safety of the equity during market turmoil.
On the debt side, DEA is positioned to withstand inflation. Fixed-rate debt constitutes 97.5% of their total debt. They have a weighted average 3.5% interest rate over 6.7 years. This debt structure is positioned to benefit from 4%+ inflation rates.
On the lease side, over 50% of lease income does not expire until after 2031. This structure provides predictable income well into the future but does not position the company well to adapt to rising inflation. However, most of the leases have provisions for inflation escalations. In their Q3 2021 10-Q report management stated this regarding inflation:
Substantially all of our leases provide for operating expense escalations. We believe inflationary increases in expenses may be at least partially offset by the operating expenses that are passed through to our tenants and by contractual rent increases. We do not believe inflation has had a material impact on our historical financial position or results of operations.
Economic Indicators are Degrading
The reason I am interested in DEA is because of a series of economic indicators that are degrading. Due to this I expect slower economic growth and lower inflation over the coming 12-24 months. It will also likely coincide with a recession.
To begin, the ISM services employment index recently hit 48.5. This drop is setting in lower lows and not supportive of improved economic activity. This trend is coinciding with a peak and fall in the Chicago PMI and ISM Manufacturing index. Often a recession begins when these indices fall below 50 and they are currently 56 and 57.
The Federal Reserve Bank of Atlanta is now estimating a Q1 2022 U.S. GDP growth of 0.0%. Data from Bloomberg Finance shows that the UMich Consumer Confidence Expectations is leading the U.S. GDP YoY growth down. It implies negative growth by the end of 2022.
Part of the reason for slower growth is that real disposable income in the U.S. has fallen back below the pre-pandemic trend line. Income from stimulus and government support has exhausted and consumers are no longer as cash-rich as they were a year ago.
The probability of a 50 basis point rate hike in March has fallen and the probability of a 25 basis point hike is now under 100%. My expectation is that the Fed will raise 25 basis points to appease markets but they are watching these data points too.
Below is the chart of the Merrill Lynch Option Volatility Estimate MOVE index. Similar to the VIX, this index is a measure of volatility in the bond market. Sharp increases in the MOVE has preceded many of the major tops in the S&P 500 over the last two decades. The latest top in the S&P 500 last month has coincided with a jump in the MOVE.
With equity markets near all-time high valuations prudent investors should be considering hedging equity risk with more stable assets. The S&P 500 is in the 95%+ percentile for CAPE valuations.
Is inflation transitory, after all?
Every now and then my contrarian spirit perks up and its perking up about inflation right now. High inflation seems to be a consensus today. The Bloomberg Businessweek cover in April 2019 “Is inflation dead?” turned out to be a great contrarian indicator. Last November Bloomberg released a new cover titled “It’s Back. Inflation. The Fear is real. But may be the monster isn’t.” Last April, Powell said inflation was transitory, but it wasn’t. Now, he says inflation isn’t transitory.
The data is supporting the contrarian idea that inflation might begin moderating. The decline in disposable income is preceding a decline in goods consumption. This implies lower goods prices.
The peak in ISM manufacturing is forecasting the peak in inflation:
Data from The Macro Compass demonstrates that the credit impulse leads inflation by 15 months and has declined steeply. The Macro Compass expects lower inflation by September of 2022 based on this data.
The conflict in Ukraine has caused a shock-wave of supply disruptions and panic in commodity markets, particularly with oil and wheat. I do not expect inflation to moderate with this ongoing crisis. However, I don’t expect the crisis to continue for long. I wrote about this concept previously. My thesis is that the world is too dependent on Russian commodities. The inflation we’re experiencing as a result of sanctions and war is already upsetting voter bases globally. With the Russian army closing in on the Capital of Kyiv I am expecting a resolution to the conflict within weeks. Peace is going to be disinflationary.
DEA owns a diversity of property types across the United States with exposure to numerous Federal agencies as tenants. Their top tenants as a percentage of lease income are:
- Department of Veterans Affairs
- Federal Bureau of Investigation
- Drug Enforcement Administration
- U.S. Citizenship and Immigration Services
- Judiciary of the U.S.
Those five account for 54.7% of company lease income. Each of these agencies provide mission critical services that are more likely to have their budgets increased over time. These facilities are more resilient to telework and remote work conversion. The tenant concentration does not concern me for two reasons: 1. the U.S. government is a very strong tenant, and 2. There is no more concentration risk than with a Treasury bond and the purpose of this position in my portfolio is a bond alternative.
The drawback for stability and security is slow growth. In 2021 the company grew FFO per share by 4%. Management is guiding for $1.34-1.36 FFO per share in 2022, a mere 3% increase YoY. The company’s 5Y CAGR of FFO is 2.29%. Consensus estimates expect FWD FFO growth of 3.52%.
An interest coverage ratio of 3.2 is acceptable, especially for the stability of the rents. The FWD dividend yield is a respectable 4.95% but it comes with a high AFFO payout ratio of 89.33%. The dividend is only expected to grow by 3.7% next year.
We can see the data from FAST Graphs demonstrates how share price consistently tracks between a P/FFO multiple of 15.0 and 17.09. At a current P/FFO multiple of 16.26 the stock is reasonably priced. During the COVID crash the stock traded up to a 24x P/FFO multiple, demonstrating the premium the market was assigning to the equity in time of fear. The stock returned a total of 84.8% from the last time the yield curve went negative in 2019 to that peak.
Below is a forecast chart based on the data and estimates from FAST Graphs. The forecasted total return CAGR over the next three years is plotted against the expected P/FFO multiple. The size of the dots represents the relative probability of occurrence according to my judgement. Based on this, I expect DEA to achieve a total return CAGR of 5-10% over the next three years.
The macroeconomic data is leading me to believe that we are entering a phase of low economic growth and approaching disinflation. This will eventually lead to a recession. I expect the Fed to try to raise rates but abandon that effort promptly. When the threat of recession can no longer be ignored I expect more stimulus and inflation to increase again.
I think investors underestimate how long real rates can remain negative, a benefit for REITs because they are debt leveraged. The primary risk to DEA is higher rates. That would cause multiple compression and the dividend yield is not high enough to overcome significant capital loss. While rates may not be finished rising yet, I expect the trend to turn down over the coming months.
I view DEA like a TIPS bond but with better inflation protection, because they own real assets, and a real yield for marginally higher risk. For those reasons it has a place in my portfolio. I have initiated a position and look to add to that position around $20.50.