Anticipating Secular Trends In REITs
- Secular trends are responsible for a good portion of stock market movement.
- It is imperative to see them before they are priced in by the market.
- We see trend reversals in self storage and senior housing.
Once a secular trend has arrived, it is already priced into the affected stocks. REITs with secular tailwinds like industrial and cell tower REITs trade at premium multiples because they are known to have powerful long term trends supporting demand for their properties. Similarly, retail REITs, which are believed to be afflicted with a secular headwind, trade at significantly discounted multiples. Thus, known secular trends provide little value to stock pickers because they are already baked in. The real opportunity comes in spotting the inflection points before they happen – identifying secular trends that are on the horizon but not yet consensus.
Upcoming inflection points
I do not claim to be an expert at identifying upcoming secular trends, nor do I have a history of successfully calling them in advance. I do not expect anyone to take my word for it that these secular trends are coming but would instead encourage judging the ideas on their own merit. We see two major inflection points coming up.
- Senior housing is flipping from a secular tailwind to a secular headwind
- Self Storage is flipping from a secular tailwind to a secular headwind
Below is our reasoning
Silver Tsunami evades ALFs and ILFs
For a long time there has been anticipation of a demographic tailwind in which a critical mass of the population reaches the ages of peak demand for assisted living and independent living facilities (ALFs and ILFs). To see the anticipation we need look no further than the presentation of just about any healthcare REIT. Senior Housing Properties Trust (SNH) graphs the long term trend in its presentation.
And Ventas (VTR) presents the data as a CAGR (presentation slide below).
Unfortunately, developers have similar anticipation and supply of senior housing has been out of control.
The demographic data is real and the companies are portraying it accurately. Where I disagree with this being a tailwind is in the capture rate. The baseline assumption made by VTR, SNH and developers is that a 5% increase in the number of 85+ year old seniors will result in a 5% increase in senior housing demand. In other words, they are assuming a constant capture rate.
This does not smell right to me.
I am a big believer in the idea that truth and rationality always prevail in the long run and the current senior housing model is not rational in the presence of the retirement crisis.
The percent of seniors hitting age 85 that are anticipated to move into senior housing is far greater than the percentage of seniors that can afford senior housing. ILFs and ALFs are extraordinarily expensive and there is simply not enough affluence to fill the growing supply of these properties.
There is simply a better way to fulfill the medical and housing needs of seniors.
- Aging in place
- Group living
- Living with a relative
- Preventive care
Low cost services like Life Alert in combination with an increasing push toward in-home medical care from mobile doctors and nurses are making it increasingly viable for seniors to live in regular homes who would previously have been sent to senior housing. It is cheaper to bring the medical staff to the senior than to have the senior live in a medical facility such as ALFs or ILFs. This allows more seniors to continue living in their own homes for longer which I suspect most people prefer.
A particularly efficient living situation is to have groups of seniors living together in a regular home. This is a brand new concept discussed in USA Today that has not yet gained a large market share. However, the sheer viability of it suggests it will take off as a superior replacement to senior housing facilities. This sort of living situation gets around all the costly regulations that inhibit senior housing facilities while allowing the seniors to split the cost of bringing medical staff to their home. It is efficient financially and goes a long way to combatting loneliness. We see this gaining substantial market share.
In other countries across the globe, seniors live with their children indefinitely. Culturally, this has not been popular in the U.S., but as the extreme cost of senior housing conflicts with the small size of average retirement savings, we suspect it will be an increasingly embraced and societally encouraged trend.
Finally, the American health care system is increasingly pushing for preventive care which will reduce the portion of people’s lives in which they are infirmed or unable to live independently. Statistically, better preventive medicine has a larger impact on quality of life than it does on duration of life. This translates to a shorter window in which ALFs or ILFs would be of use.
Overall, we seen long run troubles for senior housing real estate. Supply has been built up in an attempt to capture the silver tsunami, but the wave of seniors is flowing in a different direction. Vacancy is already elevated and the problem is likely to get worse. We are avoiding heavily senior housing focused REITs like Ventas and Welltower (WELL). Of the two, Welltower is a far better operator and we suspect VTR will continue to underperform peers.
Self storage will go from best to among the worst
Over the past 2 decades self storage has been a remarkably successful real estate sector. Occupancy growth and rental rate growth have combined multiplicatively for a truly impressive run of same store NOI growth. Self storage REITs now trade at very high multiples and I believe this is a result of the market mistakenly extrapolating its historical performance into the future.
Fundamentals have changed and the opportunity that once existed is gone. Much of the historical success was the result of these 3 factors.
A decade ago, the self storage industry was extremely fragmented. Sure Public Storage (PSA) existed, but the majority of the industry consisted of mom and pop operators, most of whom ran their businesses passively. This presented a massive opportunity for REITs to be consolidators. Not only could they scoop up the mom and pop operations at high cap rates, but then the REITs could apply highly professional management and search engine optimization to jack up the NOI from the already healthy levels.
Self storage was significantly undersupplied with just a few feet of self storage per capita in the U.S. which minimized competition between locations and paved the way for rental rate growth. Over the past couple cycles, rents have more than doubled in many MSAs.
On top of the already ample opportunity presented by fragmentation and undersupply, the REITs were able to jack up their IRRs even further through accretive HBU exits. Historically, self storage has been a low cost per foot industry which created a significant delta in converting the land for apartments or other higher density use.
Today, all three of the these drivers of historical success are diminished or entirely gone.
Fragmentation has been greatly reduced by two factors:
- Consolidation: REITs and other regional operators have gobbled up a large portion of the mom and pop operators.
- External property management: CubeSmart (CUBE) and Extra Space (EXR) have successful property management services that are contracted out to many of the remaining mom and pop owners. This removes the ability to add value through proper management as the properties are already being managed properly.
Undersupply has turned into oversupply. Developers got a bit too excited about the historical success of the sector and have overbuilt nationally. The overall supply is made worse by the NIMBY nature of self storage such that the areas in which self storage is approved by local authorities often have multiple competing self storage facilities within a very small radius. The supply would be better absorbed if it were spread more evenly across the populace.
The delta of HBU opportunities has diminished. Development costs have risen and self storage cap rates have dropped such that the current value of a self storage property is closer to that of other uses than it was in the past.
The high multiples at which self storage REITs trade only make sense if bottom lines grow rapidly. Given the oversupply, we do not see this happening. NOI growth has already stalled at the major REITs and that is before the supply wave of 2020 hits.
The only saving grace would be if the demand for self storage on a per capita basis were to increase. It has gone up historically and once again I think people are straight line extrapolating. We see demand per capita decreasing because it already beyond the point of rationality. People are already storing items at a greater cost of storage than the value of the items
This is irrational behavior.
Thus, to anticipate that demand per capital will increase not only requires this irrational behavior to continue, but it suggests the level of irrationality will increase. We see this as unlikely. I find it far more likely that the guy paying $1000 a year to store $600 worth of stuff will cancel his unit rental.
CUBE and EXR have historically been better operators than PSA so while I think the whole sector will suffer PSA looks to be the worst positioned. PSA also has older properties that are more likely to be outcompeted by the incoming supply.
I find it essential to compare fundamentals with what is implied by market prices. Senior housing REITs trade roughly at the healthcare REIT average and I think this is incorrect. Medical office and hospitals are fundamentally better positioned and should trade significantly above senior housing. If the fundamentals play out as we are anticipating, the senior housing REITs will begin to be discounted to peers as oversupply hurts profitability.
Self storage as a sector is quite pricey at over 20X forward FFO and PSA is among the highest multiple in the sector. It is priced as an extrapolation of historical growth and its share price is in for a rude awakening when organic growth rates turn negative.
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