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By Jason Born, CFA

It's an old saw, but we think it still has some cutting to do. When the California gold rush was on, the wisdom that sprung from those days was that the folks who supplied picks, shovels, and blue jeans became wealthy while miners went bust for the most part. During the Internet boom of the 1990s, Cisco Systems (CSCO) provided the "picks" for the expanding data highway and grew into an enormous company. Today, with the federal government growing ever larger, we are looking to see if there is any value in Government Properties Income Trust (GOV). GOV leases office buildings to federal, state, and other governmental organizations, and since it is organized as a REIT it pays out most of its income to shareholders, making for a fat, almost irresistible dividend yield of about 7.5%. A full 93% of its revenues come from the U.S. government, state governments, or the United Nations. Most of GOV's properties are situated in California, Maryland, Washington, D.C., New York, Georgia, and Massachusetts.

Let's get through with the basics. GOV has seen a rapid growth in revenues as it acquired more properties in recent years. Revenues in 2007 were $73 million. In 2011, they were $179 million. GOV has made the acquisitions using proceeds from new share issuance and some debt. The share issuance is a problem in that it dilutes existing shareholder ownership, but makes some sense. As a REIT, by law it must pay out most of its income. So there are only two ways to gather enough capital to make a new purchase: Either the company can issue new shares or GOV can issue debt. GOV has made the conscious decision thus far to be on the conservative end of debt issuance. Comparable REITS -- such as Washington Real Estate Trust (WRE) and First Potomac (FPO) -- both have much higher relative debt outstanding. Less debt generally means a lower return on equity (using FFO or operating cash flow, not net income, in the calculation), but may provide some added stability in challenging times such as the credit squeeze of 2008.

While on the subject of debt, GOV looks to have a very manageable load currently. Much of the debt is in the form of a term loan due in 2017, with the rest as mortgages maturing from 2015 to 2021. Nothing in its capital structure indicates that GOV could suffer a near-term liquidity crisis.

A break from the balance sheet will allow us to offer a thought on management of the REIT. GOV has no employees. It is managed by RMR, a company owned by Barry and Adam Portnoy (father and son, respectively). Barry is a trustee of the REIT and his company, RMR, receives management fees for running GOV, so RMR has an incentive to increase its management fees, a potential agency problem. That is all well and good, but it does not tell the whole tale. The Portnoys also own a company called CWH, which owns 21% of GOV. The ownership interest and dividend income from GOV far outstrip the management fees they receive, so this should put future potential shareholders at ease that the incentive structure is still more or less properly aligned with their own (always remember that it will never be perfect in a company owned by some and managed by others).

Net income for a REIT is far less meaningful than for a non-REIT company. We believe that on a per-share basis, GOV is capable of producing about $2.10 annually in funds from operations. While difficult to predict, it is important to note that we've used some alchemy to include the dilutive effect of new share issuance in coming up with $2.10, a conservative forecast. And we should be conservative, especially in the case of forecasting GOV earnings into the future. Nearly 25% of the company's rents are coming up for renewal in the next year and a half. The REIT manager expects those to be renegotiated lower because of the surplus of commercial real estate on the market. If we require an earnings yield of about 8%, a P/E (really, a P/FFO) of 12 is implied, giving us a fair value of just over $25 for GOV.

A quick trip back to the balance sheet for comparison's sake gives us an estimated value of about $22.50 based on historic P/B ratios for similar REITs. We believe that, conservatively speaking, GOV shares should be valued at somewhere between $23 and $25 per share. At a recent price of $21.95, we do not think that the market is offering us enough of a margin of safety in case our analysis proves to be insufficient. So, despite the land-grab going on with a ballooning government, we will wait for a better price.

Source: Government Properties Income Trust Is Not Cheap Enough