REITs: Storage Wars Intensify

Summary

• Storage REITs have surged over the past quarter after a dismal start to 2017. Fundamentals have continued to deteriorate, however, as supply growth and competition have intensified.
• Robust rent growth and favorable demographic trends prompted a wave of institutional money to enter the space. High levels of new development continue to weaken rent growth and pressure occupancy.
• 3Q17 earnings were generally better than expected, led by strong results from CubeSmart and ExtraSpace. Same-store revenues are expected to grow 3.5% in 2017, down from the 7.5% peak in 2015.
• We note that CubeSmart and ExtraSpace have invested heavily in technology to maximize effective rents and improve customer retention. These REITs have significantly outperformed their peers in rental metrics.
• Public Storage has fallen short of estimates in recent quarters and management doesn’t seem to have answers.  A similar investment into technology platforms could unlock substantial value for shareholders.

REIT Rankings: Self-Storage

In our REIT Rankings series, we analyze one of the fifteen REIT sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.

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Self-Storage Sector Overview

Self-storage REITs comprise roughly 8% of the REIT Index (VNQ and IYR). Within our value weighted self-storage index, we track the four largest self-storage REITs, which account for roughly $55 billion in market value: CubeSmart (CUBE), Extra Space Storage (EXR), Public Storage (PSA), and Life Storage (LSI).

While all four REITs are diversified across the country, we note the geographic and quality focus of the four REITs above. CubeSmart has a high-quality portfolio with a focus on metro areas in NYC and along the east coast. ExtraSpace has a similarly high-quality portfolio but is more evenly diversified across the country. Public Storage, the largest storage REIT, has a large west coast presence and owns a higher percentage of suburban and international assets than its peers. Life Storage has the lowest-quality portfolio of the group with a more suburban-focus in the sunbelt states.

Recent Developments and Quarterly Performance

After last earnings season, we published a report, “Storage REITs Hit Rock Bottom” where we presented a positive outlook on the sector. We wrote “Even after incorporating lowered guidance and a lower expected growth rate through 2019, our models see value in the self-storage sector relative to other REIT sectors and believe that the sell-off may be overdone. The sector ranks in the top 5 across all of our sector-metrics. If it hasn't happened already, we believe that self-storage REITs have hit 'rock bottom' and may be poised for outperformance through 2018.”

Since this time, storage REITs have been the third-best performing REIT sector, climbing 9% in this time. CubeSmart and Life Storage have been the best performers while Public Storage has lagged.

3Q17 earnings were better than expected across the sector. CUBE, EXR, and LSI beat FFO expectations while PSA lagged. CUBE and EXR raised full-year guidance while LSI maintained guidance and PSA does not provide guidance. Same-store metrics were slightly better than expected with average revenue growing 3.0% and NOI growing 2.9%.

After flying under-the-radar for many years, the robust rent growth that peaked in 2015 has prompted a wave of institutional money to enter the space. High levels of new development continue to weaken rent growth and pressure occupancy. Supply growth, which was once believed to be constrained by tight zoning regulations, has surged in recent years. Full-year 2017 revenue growth is expected to decelerate to 3.5%, down from the peak of 7.4% in 2015. Fundamentals are expected to weaken further in 2018 before recovering in 2019 as development activity cools after the “easy money” has been made.

Over the past quarter and during earnings calls, several key themes and recent developments are being discussed.

1) Supply Growth Continues to Weaken Fundamentals

First, the supply pipeline is as hot as it has ever been in the self-storage sector, which is the key threat to fundamentals. The lack of new supply in the storage sector was the driving force behind the sector’s significant outperformance in prior years. As we’ll discuss more in the next section, we are expecting to see 2.5% to 4.5% growth in supply as a percent of existing inventory, a very high and potentially troubling level. Yields on new development remain mildly attractive, which has prompted the robust growth in supply, but rising cap rates and weakening rent growth could pressure yields on new development plans and sideline marginal projects. Supply growth has been most acute in the major metropolitan areas and less troublesome in secondary markets. Denver, Nashville, New York, Miami, and Boston will continue to face issues with oversupply in the coming quarters. Public Storage management sees more supply pressure in the coming quarters but is hopeful that deteriorating fundamentals will slow the development pipeline. From the PSA earnings call:

“The tone is changed with respect to developing properties and getting 4%, 5% rate increases in revenue, quick fill-up and all that kind of stuff. I think it's going to be we'll have pretty meaningful uptick and supply this year. I don't know about next year, but even if we have a meaningful reduction, extra is going to be a couple years as each property fills up.”

2) Demand Remains Strong For EXR and CUBE, Weak For PSA

The drastically different outlook on demand has been one of the most intriguing developments in the last few quarters. CUBE and EXR have been significantly more upbeat about demand metrics while PSA has painted a dark outlook. While this could be attributed to market-specific dynamics, the intensification of this trend has certainly raised questions and has us wondering if storage fundamentals really are this weak or if PSA management is simply failing to execute. Of course, the third possibility is that EXR and CUBE are simply executing on a level that far exceeds the market. From the PSA earnings call:

“There is very little room to really push for rental rates at the moment, because demand still remains very soft throughout the country for us…We're not seen any markets with accelerating rates of revenue growth. All 20 were down, I think that's the third or fourth quarter in a row.”

This is in stark contrast to the rather rosy outlook expressed by EXR’s management. From the EXR earnings call:

“The fundamentals in storage are healthy. Demand has been steady resulting in growth in occupancy and rental rates. As expected, the rate of our revenue growth is moderated since the beginning of the year, but the rate of the moderation is flattening. We are confident that our systems are well equipped to maximize revenue in the current environment and our team has demonstrated a track record of consistent execution.”

3) CUBE and EXR’s Focus on Data-Driven Technology Systems

CUBE and EXR, the two REITs that have invested the most in technology, have outperformed over the past two years and continue to beat estimates. These REITs continue to cite data analytics as a crucial element in driving growth in effective rents and customer retention. PSA and LSI, on the other hand, continue to underperform and have fallen short of earnings estimates for most of the past two years. For several quarters, we have raised questions about PSA management’s “old-school” approach towards pricing and customer acquisition. EXR and CUBE have developed a fast-growing third-party management business which has used this technology platform to generate fee income. In our opinion, the success of this third-party platform is an affirmation of the strength of their technological platform. From the CUBE earnings call:

“We’re on pace for a really spectacular year this year in terms of overall growth to the third-party program…I think we will have another very robust [2018]."

Public Storage has fallen short of estimates in recent quarters and management doesn’t seem to have answers. We first raised the issue over Public Storage’s lack of investment in technology early in 2016 after the REITWeek conference after the company noted that it didn’t know the demographics of its customers. Meanwhile, EXR and CUBE are running their advanced pricing algorithms in many of Public Storage’s markets and “eating their lunch” so to speak. A similar investment into technology platforms could unlock substantial value for shareholders. Given the size and investment capacity of PSA, we believe this could be a positive catalyst in the coming quarters.

Below is our REIT Heat Map, showing the quarterly performance in relation to other sectors. Storage REITs have underperformed the broader REIT index YTD, but have outperformed in the past quarter. We also highlight the strength in the S&P 500 (SPY) and the decline in the 10-Year Yield (IEF).

3 Reasons To Be Bullish on Storage REITs

1) Demand Greenshoots Remain Relatively Strong

Demand for space in these facilities has been accelerating over the past decade as homeownership rates dip to record lows. Self-storage demand is driven by change: moving houses, going to college, having kids, changing styles, and getting older, to name a few. Americans have been going through more “change” than in the past. The “rent-by-choice” preference that began after the housing crash of the recession shows few signs of reversing and homeownership is currently near multi-decade lows. While homeowners can use their garage and basement for their storage needs, renters rarely have that luxury. Payroll growth has supported demand fundamentals, as has the increased rate of job turnover in recent years.

2) Long Runway for Acquisition-Fueled Growth

The self-storage industry is a highly fragmented industry with these four REITs owning less than 20% of the total square footage in the US and about one-third of the total “institutional quality” market. The technology and brand value of these REITs are a competitive advantage over private market competitors and continued consolidation would make strategic sense over the next the decade. Like the net lease sector, these REITs typically enjoy a significant cost of capital advantage over private competitors and we expect these REITs to ramp up acquisition efforts once share prices command Net Asset Value premiums. (EXR Investor Presentation)

3) Sticky Customer Base

Roughly one in ten Americans currently rent space in a self-storage facility. These 30 million Americans park their possessions in one of 60,000 self-storage facilities throughout the country. Proximity to one’s home (generally 3-5 miles) is cited as the most important feature of these 100 square feet of space. 70% of customers are residential, with the other 30% split between businesses, students, and the military. Self-storage demand tends to be ‘sticky’ in part because of the economics of ‘sunk costs.’ Many renters admit to spending more money to store their possessions than they are actually worth and many are reluctant to ever recognize the sunk cost. Nearly half of self-storage customers rent their unit for more than two years. This sticky customer base leads to predictable and recurring demand trends.

2 Reasons To Be Bearish on Storage REITs

1) Supply Pressure Continues to Intensify

While demand for self-storage units over the past decade has been robust, supply had lagged considerably until 2014. Investors in self-storage REITs enjoyed this supply/demand imbalance as market rental rates for existing units has increased by over 10% per year in many major markets. Supply has since increased considerably over the past three years, though. Roughly 800 facilities were built in 2016 and data provider STR estimates that there are 840 new self-storage facilities under construction or in the planning phases in the top 25 metro areas. A significant source of supply growth is also coming from expansions to existing facilities. Combined, we are likely to see supply growth as a percent of existing inventory in the 2.5% to 4.5% range for both 2017 and 2018, a very significant and somewhat troubling level of supply growth that will certainly put near-term downward pressure on rent growth.

2) Structural Changes in Demand: Experiences, Not Things

There are several potential structural changes in consumer spending that could negatively impact the long-term picture for storage demand. First, consumers (particularly millennials) are increasingly spending a higher percentage of their disposable income towards “experiences” rather than “things.” Further, the “things” that consumers do buy are increasingly non-storable goods such as phones and other electronics rather than clothing, books, and recreational equipment. Second, business demand is likely weakening as a result of a switch to digital file storage. A significant percentage of business storage demand is related to regulation-mandated file storage. Most regulatory agencies now allow digital file storage. These two factors could combine to weaken the long-term outlook for storage demand.

Valuation of Storage REITs

Compared to the twelve other REIT sectors, storage REITs appear cheap, trading at sizeable discounts to the REIT averages. Storage REITs are the sixth cheapest sector on both current and forward Free Cash Flows. When we factor in five-year growth expectations in the FCF/G metric, the sector appears slightly less attractive.

(Hoya Capital Real Estate estimates, Company Filings)

Within the sector, all four names appear fairly attractive at these levels relative to other REIT sectors. Even after incorporating lowered guidance and a lower expected growth rate through 2019, our models see value in the self-storage sector relative to other REIT sectors and believe that the sell-off continues to be overdone. The sector ranks in the top 5 across all of our sector-metrics.

Sensitivities to Equities and Interest Rates

In recent quarters, as their growth rates have slowed, self-storage REITs have become increasingly more interest-rate sensitive.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. (click to read more information about our methodology). As a sector, self-storage REITs fall into the Yield REIT category.

Within the sector, we classify the four names as either Yield, Growth, or Hybrid REITs based on our calculations. All four REITs fall into the Yield REIT category.

Dividend Yield and Payout Ratio

Based on dividend yield, storage REITs rank in the middle, paying an average yield of 3.8%. Storage REITs payout 80% of their available cash flow.

Within the sector, we see that Life Storage pays the highest yield at 4.6%, but is also expected to see the slowest growth over the next several years.

Bottom Line: After Hitting Rock Bottom, A Turnaround May Continue

Storage REITs have surged over the past quarter after a dismal start to 2017. Fundamentals have continued to deteriorate, however, as supply growth and competition have intensified. Robust rent growth and favorable demographic trends prompted a wave of institutional money to enter the space. High levels of new development continue to weaken rent growth and pressure occupancy.

3Q17 earnings were generally better than expected, led by strong results from CubeSmart and ExtraSpace. Same-store revenue is expected to grow 3.5% in 2017, down from the 7.5% peak in 2015. We note that CubeSmart and ExtraSpace have invested heavily in technology to maximize effective rents and improve customer retention. These REITs have significantly outperformed their peers in rental metrics.

Public Storage has fallen short of estimates in recent quarters and management doesn’t seem to have answers. A similar investment into technology platforms could unlock substantial value for shareholders.

We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage, and long-term operating performance are all considered within the ranking.

We currently view Public Storage and CubeSmart as the most attractively valued names within the sector. To see where storage REITs fit into a diversified REIT portfolio, be sure to check out our other REIT Rankings for all fifteen REIT sectors: Data Centers, Apartments, Malls, Self-Storage, Manufactured Housing, Healthcare, Net Lease, Single Family Rentals, Hotels, Cell Towers, and Office, and Shopping Centers, Student Housing, and International.

Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long VNQ, SPY, MAA, CPT, OHI, PLD, GGP, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP, EQR, INVH, SPG, HST, TCO. 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.