Public Storage (NYSE:PSA) is not the REIT to own if you expect the U.S. economy to finally regain strength next year under a new administration. Earnings could decline if the economy becomes robust; if interest rates rise with economic expansion, share price could drop as the yield adjusts to the higher interest rates.
PSA was a great investment to own during the anemic growth after the housing crisis. I owned it for a number of years until I sold my holdings in 2015.
During the 2008-2010 economic crisis, PSA was impacted as customers sold belongings to raise cash instead of storing them, small businesses that used the storage facilities closed, and the very high rental turn-over reduced the occupancy rate. In addition, these new customers usually paid a lower introductory rental rate than those vacating their units. As new customers who down-sized their living quarters rented, their customer base stabilized, which resulted in very impressive gains for the last 6 years.
Many REITs benefit by stronger economic growth and have increased distributions that offset the negative impact of higher interest rates and comparative yields. With a stronger economy, many of PSA's customers will "upsize" and move their belongings, which they have been storing, into larger homes. Some will be buying houses, while others will be renting larger apartments.
Many renters of storage units do it because they have to and not because they want to. There is a big difference, especially for PSA customers. During and after the housing crisis, there was widespread downsizing in this country. As I stated above, PSA customers had less room for their belongings in their new, smaller living quarters, and put them in storage. Some have been paying monthly storage rent for a long time — more than 57% of PSA customers rent longer than one year — and will be relieved when the economy becomes stronger and they finally are able to move these stored items into their new homes.
PSA has a diversified portfolio of storage facilities. Some are outside, metal, one-story garages and others are indoors in climate-controlled warehouse buildings. Often within these warehouses you have a large variety of units, from 20x10 rooms to small 4x4x4 lockers. Fortunately for PSA, many of their facilities are located in regions that were the hardest hit during the housing crisis. The pricing varies widely by location, because the industry is very competitive. While PSA is the largest in the country, it only has a 5% to 6% of national market share. There are many small operators because of the low cost to build storage garages — about $1,500 per unit, not including land. Indoor facilities, however, are much more expensive to build.
Besides their portfolio of storage facilities, they own a 42% equity in a REIT, PS Business Park (NYSE: PSB), that owns and operates commercial property. They also own a 49% equity in Shurgard Self Storage Europe Ltd, which owns and operates self-storage properties in Europe.
Ancillary income from sale of boxes, locks, and rental insurance is an important addition to the profitability of storage properties. The profit form these sales was almost 8% of total net profit in 2015. They are often more expensive than other retail stores, but are purchased because of the convenience by renters. Just like banks, late fees are considered a profit center, but they have been declining as more people use the automatic debit available or pay their rent on-line.
Growth has come from building new facilities and purchasing existing ones. Usually PSA raises rents almost immediately for newly acquired properties. PSA prices competitively to their local market, but at a modest premium to other storage companies. They offer a teaser introduction rate and then raises rents at least once a year for as long as that customer rents. The difference between the introductory special rates and what a long-term renter pays continues to widen the longer they rent. Some eventually move to a competitor that also offers special low introductory rates.
This turn-over has a negative impact on the occupancy rate. PSA has been successful in increasing their occupancy rate, but with a current 94% occupancy rate they may have reached the maximum level since customers do not have to give notice prior to vacating a unit, and there is often a few days or longer of vacancy between outgoing and incoming customers.
PSA has a conservative capital structure: Debt at 3.6%, 46.8% preferred stock, and 49.6% equity, as of its March 31, 2016 statement. A different way to look at the structure is to use the current market value of equity: The debt is 0.7%, preferred 9.0% and equity 90.3%. Their preferred rates range from 4.95% (newly issued) to 6.50%, therefore, some future cashflow savings could result when higher-rate preferreds are refinanced.
Often annual revenue per rentable square foot is a measurement used in analyzing real estate. I would rather use per rentable cubic foot when analyzing storage facilities, but that data is not disclosed in filings. Here is the issue. Storage lockers are often stacked 3-4 high in an indoor warehouse that has high ceilings. Some of these storage lockers are only 4x4x4 (others are larger) and on other floors there are storage rooms that range from 5x5x8 to 12x12x8. By grouping all of these units plus storage garage-type units together makes for poor quality analysis of the available data.
Table notes: Square footage adjusted to reflect less than 100% ownership of properties. Rent multiple based on U.S. rates; international rates are somewhat higher, but do not significantly influence overall result.
Declining home ownership rates are music to the ears of investors in storage facilities. Renters are more likely to move more often than home owners, which often requires short-term storage rentals, plus they have less room in their apartments for their belongings and rent units for supplemental storage. Even with low mortgage rates, home ownership has declined. This is partially due to seniors renting out their former homes instead of selling them to get a better return on investment than buying U.S. treasuries with the proceeds from the sale. This could change if and when treasury rates rise in the future.
Some storage investors are expecting that retiring baby boomers will create a stream of new storage renters as they move into smaller living spaces after retiring. I disagree. I think seniors will give away to relatives or sell unneeded belongings. They will not waste money on renting storage units knowing that they will not be using their belongings again in the future. People rent storage space with the expectation they will vacate it at some point in the future.
Storage facilities are viewed by much of the public on about the same level as pawn shops. They often even decrease adjacent property values. There is a storage company in New York City, Manhattan Mini-Storage, that has been trying to change that perception by the public by using very hip, humorous ads. One funny ad even included a customer dressed in drag. They are trying to expand their market beyond the typical storage renter to include upscale customers storing expensive bikes during the off-season, or collectors' valuable items. They have succeeded in taking some of the sigma out of renting storage units. PSA, on the other hand, continues to market their facilities as they have for decades, assuming what has worked well in the past will continue to work.
There are now even businesses that offer to pick-up boxes from and re-deliver directly to customers without the customer having to set foot in a storage facility. These competitors are selling convenience. When boxes are not large enough for the items to be stored, there are also companies that pick up and re-deliver larger containers that can accommodate small furniture. PSA has not expanded into this market.
Poor Customer Service
As an investor, I place great deal of importance on customer service when analyzing a company. Over the years, I have had discussions with various levels of PSA management. While there are some customer service-oriented employees at various facilities, middle and upper PSA management is not customer-service oriented; they are real-estate-focused. That is a major problem with PSA. After reading online reviews from PSA customers, I talked to management to try to get their side of the issues raised in the reviews. I was not pleased with their responses.
For example, it took three days for a PSA employee to cut a lock for a customer who left their key in the storage unit. I would assume that this is most likely a fairy common occurrence. When I asked a regional manager about this issue, he thought three days was quick, and great customer service. The costumer in their review thought otherwise, and was hoping for a much quicker lock cut. I further asked this regional manager if the lag time would encourage customers to just get a hacksaw and cut it themselves. He stated that this was not allowed, but it seems that from reading other reviews customers do in fact cut their own locks. I can only imagine what other customers must think when they see another customer walking around the storage facility with a hacksaw.
Upon further discussion of other reviews, I was told by the same regional manager, "…well, you have to consider what type of person rents storage units." I called PSA corporate headquarters and got the same type of responses from various members of senior management. I consider this a yellow flag. Poor customer service has killed many companies, such as the Kmart and Radio Shack — though I am not expecting PSA to follow Kmart or Radio Shack into bankruptcy.
The Hughes family members own about 15% and still control PSA. I was wrong when I expected PSA could be a target of Bernie Sanders during his presidential campaign. The Hughes are very active conservative Republicans, and REITs have been on Sanders's hit list of tax loopholes that need to be changed. Therefore, I expected Sanders to not only attack REITs, but single out PSA and the founder, P. Wayne Hughes, for a major negative PR assault. It never happened. With the Democratic Party moving further left, the tax advantages associated with REITs could still be reduced or eliminated if Democrats gain control of the federal government.
While PSA has had great growth during these troubled economic years and has a very strong balance sheet, I expect some serious problems in the future. If the economy dramatically improves, I expect storage renters will vacate their units as they are finally able to upsize their living quarters. Some of these renters may be replaced be newly formed businesses, but their introductory rental rates most likely be lower than the long-term renter that vacated the same unit. The higher turnover also hurts the occupancy rate and thus profits. An improving economy may encourage more renters to buy homes, which means fewer apartment renters, who tend to move more often than homeowners.
The current valuation of PSA's assets, as measured by capitalization value of $259 per adjusted square foot, is way too high. The valuation of assets as measured by the rental rates multiple has doubled in the last six years. As interest rates increase, with the economy becoming more robust, I would expect the price to decline to adjust the current yield of 2.86% to reflect these higher interest rates. There are also yellow flags in management not being customer-friendly and the shifting of the Democratic Party further to the left, which could impact tax breaks for REITs. I consider PSA a sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.