Tickers in this Article: CXW, GEO, SDXOF, SPG, BXP, VNQ
Commercial real estate continues to be a top draw for investors. Driven by the search for income, hard asset exposure, as well as market beating gains, investors have poured countless dollars into broad real estate funds like the Vanguard REIT Index ETF (ARCA:VNQ). So far, investors in real estate trusts (REITs) have been well rewarded for their gamble. Since the end of the Great Recession, commercial real estate has been one of the best performing asset classes.

However, the best performers haven’t been traditional real estate sectors like apartment buildings, office plazas and shopping centers- but alternative property types. One of the more interesting and potentially profitable for investors can be found in a seedier sector of the market- operating private prisons.

SEE: How To Assess A Real Estate Investment Trust (REIT)

Making Crime Pay
Believe it or not, crime can pay for investors and their portfolios. That is if they focus on the lucrative world of operating for-profit prisons. As states grapple with budget deficits and higher spending issues, many have turned to farming-out their corrections facility operations to private companies. Often with considerable savings and success. For example, Ohio- as a way to climb out of an $8 billion budget deficit- began the process of privatizing their prisons in 2011. Since that time, The Ohio Department of Rehabilitation and Correction has boasted roughly $3 million in savings per facility.

These budget issues are compounded when adding in the fact that we love to lock-up inmates in America. Currently, the U.S. has the highest incarceration rate of any developed nation.

According to Bureau of Justice Statistics (BJS), the United States sends roughly 754 per 100,000 people to jail. The U.S. only represents about 5% of the total global population, but its inmate population is a nearly a quarter of all those incarcerated around the world. More importantly, that inmate population is growing at a 5% annual rate. As such, state prisons currently have a 96% occupancy rate, while federal prisons are at 140% of capacity. In some areas, prisons are so overcrowded that criminals are being released early.

All in all, these two tailwinds will benefit private prison operators GEO Group (NYSE:GEO) and Corrections Corporation of America (NYSE:CXW). Together, these firms currently operate around 75% of the for-profit prison market in the United States.

SEE: Unusual Assets Owned By Hedge Funds

The REIT Way
Aside from growth in privatizing prisons, both firms have another ace up their sleeves for investors- they are in the process of converting into REITs. Through IRS special letter rulings, both firms will turn into tax/corporate structure. Similar to mall owner Simon Property Group (NYSE:SPG) or office building firm Boston Properties (NYSE:BXP), both GEO and CXW will be able to benefit from the special tax treatment as- believe or not- running a prison is actually very similar to running an apartment complex or other “rentable” property. For investors, that could mean some high dividends as REITs are required to disburse 90% of their income to shareholders by way of payouts.

Corrections Corporation of America is the larger and older of the two firms. The company houses more than 80,000 inmates across 47 wholly-owned and managed correctional/detention facilities as well as 20 other managed prisons. Under the REIT conversion, the company expects to save $70 million in 2013 and funnel that back to shareholders. Corrections Corp recently declared a monster special dividend and yields an impressive 6.1%.

However, there could be a red flag for shares. The company acknowledged that some of its employees falsified nearly 4,800 hours of staffing records in violation of its contract with the Idaho. That could come back to bite the firm.

Meaning investors may want to give rival, GEO Group a-go. The firm currently is 70% “leased” and recently increased its annual dividend from 80 cents per share to $2. That’s a pretty juicy 5.3% yield. While it’s not as big as CXW, GEO Group could be a better buy as it currently is undervalued versus its peer on FFO metrics.

The Bottom Line
While it’s not a glamorous business, operating for-profit prisons is quite a money maker. Rising prison populations coupled with declining state budgets will be a windfall fall for private correctional facilities operators. Both GEO Group and Corrections Corporation of America as well as prison manager Sodexo S.A. (OTC:SDXOF) could be huge winners for investors over the longer term.

At the time of writing, Aaron Levitt did not own shares in any of the companies or funds mentioned in this article.

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