Both have significantly underperformed the S&P 500 since their conversion. That's due to two major issues: poor financial performance and a shift in society's view on private prison ownership.
CoreCivic's financial performance has declined since becoming a REIT. In 2012 -- its last year as a traditional C-corp -- the company produced $157 million of net income and $423 million of adjusted EBITDA. Fast forward seven years and the company had only generated $146 million of net income and $420 million of adjusted EBITDA during the last twelve months ending in June of 2020.
That decline in earnings came even though the REIT has significantly expanded its asset base, causing its leverage ratio to rise from 2.6 times debt-to-EBITDA in 2012 to 3.9 times debt-to-EBITDA in 2020. The company blames its underperformance on the need to pay a high dividend to maintain its REIT status, which caused it to borrow money to fund growth instead of retaining cash flow.
GEO Group has done a slightly better job at growing its earnings over the years. In 2012, the REIT generated $215.7 million of AFFO and $389.8 million of NOI. It's on track to produce $292 million to $294.5 million of AFFO in 2020, along with $607.5 million to $610 million of NOI. However, on a per-share basis, AFFO has declined from $3.52 in 2012 to an anticipated range of $2.43 to $2.45 in 2020. That's due to a nearly 30% increase in the company's average diluted shares outstanding since it became a REIT because it issued new shares to help finance growth.
Both REITs have struggled to create shareholder value because it has become increasingly challenging for private prison operators to access capital (equity and debt) due to societal pressures. A growing number of people see private prisons as part of the problem and not a solution to fix America's criminal justice system because they're profiting from incarceration. Thus, there's a perceived incentive to keep people in these facilities instead of helping them reenter society where they can become functioning members instead of falling into recidivism. While both REITs are increasing their focus on community reentry efforts, that hasn't helped fix the industry's image problem.
That issue has had a significant financial impact on prison REITs. Several major banks have pledged not to lend money to private operators of prisons and detention centers because the sector doesn't align with their environmental, social, and governance (ESG) initiatives. Meanwhile, lawmakers have put pressure on the sector, with some seeking to end the use of private prison operators.
Finally, investors have soured on the industry due to concerns about ESG, potential new regulations, and the sector's chronic underperformance. That's making it more challenging and expensive for prison REITs to raise outside capital to fund expansion, which has caused their share counts and leverage levels to rise, putting additional pressure on their stock prices.
What does the future hold for prison REITs?
Industry conditions have gotten so challenging that CoreCivic decided to abandon the REIT structure and convert back into a corporation starting in 2021. That will allow the company to retain more cash since it won't need to make a minimum required dividend payment to maintain compliance with IRS guidance for REITs.
The company initially intends to use that cash to pay down debt. Once it reaches its targeted leverage ratio of 2.25 to 2.75 times debt-to-EBITDA, it plans to return a substantial portion of its free cash flow to shareholders via share repurchases and future dividends. It will also fund growth opportunities, including developing new facilities in its property segment and pursuing new community services that weren't available under the REIT structure.
On the other hand, GEO Group plans to remain a publicly traded REIT. However, the company did reduce its quarterly dividend by 29% in late 2020 to retain more cash to repay debt. That move will give it additional financial flexibility as it navigates through the sector's challenges.
The bottom line on prison REITs
Prison REITs have struggled to create value for investors since the subgroup formed in 2013. That's leading CoreCivic to exit the sector. While Geo Group remains committed to the structure, it, too, could head for the exit if investors don't buy into its strategy and its peer delivers higher returns. When combined with the sector's perception issues, that unknown future of the remaining prison REIT makes it an unappealing option for REIT investors these days.