REIT Rankings: Self-Storage
In our REIT Rankings series, we introduce and update readers each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.
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Storage REIT Sector Overview
In the Hoya Capital Storage REIT Index, we track the five largest self-storage REITs, which account for roughly $75 billion in market value: Public Storage (PSA), Extra Space Storage (EXR), CubeSmart (CUBE), Life Storage (LSI), and National Storage Affiliates Trust (NSA). Often viewed as an extension of the residential REIT sector due to high correlations with the multifamily and single-family rental sectors, self-storage REITs comprise roughly 8% of the broad-based REIT ETFs (VNQ and IYR).
Self-storage units are the "Hotel California" of the real estate sector: once you're checked-in, "you can never leave." Despite storage units typically being rented on a month-by-month basis, nearly half of renters stay longer than two years, and many of the 30 million self-storage renters in America park their possessions in a storage unit for a decade or more. There are roughly 50,000 self-storage facilities throughout the country and proximity to one's home (generally 3-5 miles) is cited as the most important feature. 70% of customers are residential, with the other 30% split between businesses, students, and the military.
The self-storage industry is a highly fragmented industry. These five REITs own roughly 20% of the total square footage in the US and about one-third of the total "institutional quality" market and we believe that industry consolidation is one of the key potential drivers of self-storage outperformance in the next decade. Revenue management technology, brand value, and cost of capital have historically given these REITs a competitive advantage over private market competitors and smaller brands.
"Renter Nation" has been a boon for self-storage REITs, a property type where demand is driven by growth in household formations and underlying change within these households. Declining homeownership rates, boomer downsizing, and a strong labor market have been key demand catalysts in recent years. According to a Marcus & Millichap report, millennials represent nearly a third of non-commercial storage demand and tend to visit facilities far more frequently than older generations.
For self-storage REITs, the business is almost too good. Developers and new operators have flocked to the sector in recent years, adding new supply at a furious rate, weakening fundamentals, which hit "rock bottom" in early 2018. The operating efficiency and relative simplicity of the self-storage business is second to none in the real estate sector, where properties can break even at sub-50% occupancy rates, even with sub-par management.
These REITs themselves have been enablers-of-sorts to this supply growth through their third-party management offerings, which has allowed to lower the barriers to entry for new development. While self-storage demand has been robust throughout this decade, long-term demand for storage space from businesses and the military for paper file storage may be impaired by the growing application of digital file storage, which may weaken marginal demand.
While all five 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. Extra Space 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 and National Storage have the lowest average-rent portfolio of the group with a more suburban focus in the sunbelt states.
Linked to the performance of the residential REIT sector, roughly one in ten US households rents a self-storage and annual industry revenue totals nearly $50 billion. Self-storage REITs comprise roughly 3-4% of the Hoya Capital Housing 100 Index, which tracks the GDP-weighted performance of the US Housing Industry.
Fundamental Performance of Self-Storage REITs
For the self-storage REIT sector, 2Q19 earnings season continued a streak of better-than-expected results as robust demand - bolstered by a sticky existing tenant base - has more than offset the still-elevated levels of supply growth. In late 2017, we published a fundamental analysis of the self-storage sector, Self Storage REITs Hit Rock Bottom, in which we concluded:
Even after incorporating lowered guidance and a lower expected growth rate through 2019, though, our models see value in the self-storage sector relative to other REIT sectors and believe that the sell-off may be overdone. If it hasn't happened already, we believe that self-storage REITs have hit 'rock bottom' and may be poised for outperformance through 2018.
As luck would have it, self-storage REITs have indeed significantly outperformed the broader REIT average since precisely this time as rent growth and underlying fundamentals have stabilized over the last several quarters. The producer price index for mini-warehouse and self-storage, which has historically exhibited a near-perfect correlation with self-storage rent growth, grew 2.6% on a year-over-year basis in June. Self-storage rent growth continues to closely track the multifamily sector, which has seen a notable reacceleration since mid-2018, which we discussed in Apartment REITs: Roaring Rents.
Self-storage REITs delivered same-store revenue growth of 2.4%, the fourth straight quarter of sequential improvement. Expense growth, however, ticked higher on elevated levels of marketing spending and property taxes. While "street rates" (essentially new leases) continued to see negative year-on-year growth, realized rents still climbed 2.1%, reflecting the still-strong renewal rent growth on existing tenants as occupancy remained firm in the quarter.
While metrics have indeed stabilized - and even accelerated in some cases - over the last four quarters, the sector is not completely out of the woods yet. On a trailing 12-month average, as reported by NAREIT's T-Tracker, same-store NOI growth ticked to the slowest rate of growth since 2010. Pressured by supply growth, NOI growth averaged just 2% in 2018, the first year that the sector has underperformed the broader REIT average since 2009.
The lack of new supply in the storage sector was the driving force behind the sector's significant outperformance in prior years. While supply growth appears to have peaked in 2018 at more than 4% of existing inventory, deliveries are expected to remain elevated through 2020. Supply growth has been most acute in the major metropolitan areas and less troublesome in secondary markets. Assets in markets with heightened supply growth generally see a 1-4% slowdown in same-store revenue, depending on the proximity and characteristics of the competitive location.
Reflecting the broader sector-wide conditions, the storage REIT development pipeline has finally pulled back from the peak in 2015 and has been shrinking over the last two years dating back to mid-2017. A double-edged sword for storage REITs which are some of the biggest culprits of adding new supply, development yields remain moderately attractive, which means that the new supply pipeline will remain at least somewhat active through 2020 and potentially beyond.
Three of the four REITs that report guidance boosted their full-year same-store NOI guidance while all four REITs boosted their full-year FFO outlook. (PSA still does not provide guidance). These REITs now see an average of 1.5% growth in same-store revenues, up from initial estimates of below 1%. National Storage provided the most significant boost in guidance, revising its same-store outlook higher by 100 basis points from last quarter to 4.0%.
Core FFO growth, which rose by more than 13% from 2013-2016, continues to decelerate across the sector, but the extent of the decline is not as significant as once feared as all four REITs boosted full-year FFO guidance. Core FFO growth rose by 4.2% in 2018, led by National Storage and Extra Space. Growth is expected to average less than 3% in 2019, but the return of the NAV premium amid the broader REIT rally of 2019 should re-open some accretive external growth opportunities by the end of the year if valuations persist.
On that point, self-storage REITs have historically been among the most active acquirers in the REIT sector, using their persistent NAV premium to fuel external growth. The sector struggled with a deteriorated cost of capital advantage in recent years, but solid outperformance over the last 18 months has restored the coveted NAV premium. The sector was again net buyers in 2Q19, purchasing a net $106 million in assets.
A key theme that we discuss is the strong operating efficiency profile of self-storage facilities, which has been a double-edged sword for these REITs. More than most REIT sectors, cash flow coming into the business ends up in the pockets of investors. Commanding some of the highest operating margins and lowest G&A overhead margins in the real estate space, self-storage facilities can operate profitably with occupancy as low as 50% or less. The relatively low barriers to entry, combined with strong fundamentals between 2012 and 2016, promoted a wave of new development across the sector.
We continue to see industry consolidation as a key long-term growth opportunity for self-storage REITs, which we believe command competitive advantages through their brand value, operating efficiency, and superior technology platforms. Third-party management is one area of the storage sector that has many investors excited about future high-margin growth opportunities. Public Storage calls it the "Amazon strategy", in which REITs collect a percentage of revenue from private storage operators for the use of their brand and technology platform. As discussed in the last report, we think it's more comparable to the hotel management business, where operators like Marriott (NASDAQ:MAR) are able to use their brand value and operational expertise to capture significant economic value.
(Source: EXR Investor Presentation)
Recent & Long-Term Stock Performance
Storage REITs, the darlings of the REIT sector from 2010 through 2015, were perhaps the best-kept secret within the REIT investment community. The sector delivered a 28% average annualized total return in that six-year span, a stretch of outperformance that is rivaled only by the recent run by the manufactured housing REIT sector, which is on pace to outperform for a record seven straight years this year.
After underperforming in 2016 and 2017, storage REITs returned to their winning ways in 2018, delivering a total return of 3% in 2018 compared to the FTSE Equity REIT Index total return of -4%. Storage REITs have continued their momentum through the first eight months of 2019, surging nearly 30% as fundamentals continue to improve as supply growth gradually recedes. Storage REITs have outpaced the broader REIT index by roughly 600 basis points since the start of 2019.
Extra Space and Public Storage have been the top performer of 2019, followed by National Storage and CubeSmart. Life Storage has been the laggard after delivering sector-leading performance last year. Self-storage sector has been particularly strong over the last four months, as the sector has climbed more than 9% amid a period of increased market volatility.
Valuation of Storage REITs
For much of the post-recession period, storage REITs traded at sizable premiums to the REIT average, but valuations have come back towards the REIT sector averages since the relative underperformance began in 2016. For a brief period in 2018, storage REITs traded at a Free Cash Flow (aka AFFO, FAD, CAD) discount to the REIT sector averages, but have regained their premium multiple given their recent stretch out solid outperformance. Despite the slowdown in FFO growth over the past three years, storage REITs still rank in the top half of the REIT sector in average FFO growth rates over the past five years. Helping to kick-start the acquisition channel, storage REITs are again trading at sizable NAV premiums, estimated at 25-35% by consensus estimates.
Storage REITs Dividend Yield and Payout Ratio
Based on dividend yield, storage REITs rank in the middle, paying an average yield of 3.2%. Storage REITs pay out roughly 70% of their available cash flow, leaving sufficient cash flow for development and acquisition-based external growth.
Within the sector, we see that Life Storage and National Storage pay yields closer to 4% while the three larger REITs pay more modest yields. Generally, we think that growth-oriented investors, particularly in taxable accounts, should prefer REITs with more modest payout ratios that focus on retaining capital to drive further FFO growth.
Storage REITs & Interest Rates
In recent years, as their growth rates have slowed, storage REITs have become increasingly more interest rate sensitive. The relatively defensive nature of the sector contributes to its more bond-like properties relative to other real estate sectors. The sector exhibits relatively high interest-rate sensitivity but has among the lowest correlations with equity markets.
We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. As a sector, storage REITs fall into the Yield REIT category, reflecting that these REITs exhibit elevated levels of interest rate sensitivity.
Bottom Line: Improving Outlook for Storage REITs
Self-storage units are the "Hotel California" of the real estate sector: once you're checked-in, "you can never leave." A sticky tenant base has supported the sector despite record supply growth. For self-storage REITs, the business is almost too good. Developers and new operators have flocked to the sector in recent years, adding new supply at a furious rate, weakening fundamentals.
The operating efficiency and relative simplicity of the self-storage business are second to none in the real estate sector, where properties can break even at sub-50% occupancy rates with sub-par management. Storage REITs hit "rock bottom" in 2018 and have turned the corner since then. Storage REITs have jumped nearly 30% this year as 2Q19 earnings continued the positive momentum.
Essentially an extension of the residential REIT sector, the demographic-driven reacceleration in multi-family and single-family rent growth since bodes well for a continued recovery into the 2020s. A recovering NAV premium should re-open the external growth pipeline, which has historically been a key source of FFO growth. If these REITs can retain their NAV premium throughout 2019 and begin to reassert their cost of capital competitive advantage, we think current guidance may prove overly conservative.
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Disclosure: I am/we are long PSA, CUBE, EXR, VNQ. 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.
Additional disclosure: I am/we are long EQIX, DLR, COR, VNQ. 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. Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
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