(Hoya Capital Real Estate, Co-Produced with Brad Thomas)
"Change" is proving to be a good thing for self-storage REITs, which stumbled into the 2020s with challenged fundamentals and a strained outlook but have delivered notable outperformance amid the coronavirus pandemic. In the Hoya Capital Self-Storage REIT Index, we track the five largest self-storage REITs, which account for roughly $60 billion in market value: Public Storage (PSA), Extra Space (EXR), CubeSmart (CUBE), Life Storage (LSI), and National Storage Affiliates (NSA). While we focus this report on these consumer-focused storage operators, we also track business storage REIT Iron Mountain (IRM), which also operates a small portfolio of data centers.
There are roughly 50,000 self-storage facilities in the United States, and proximity to one's home (generally 3-5 miles) is cited as the most important feature. Roughly, one in ten US households rent a self-storage unit, and 70% of self-storage customers are residential, with the other 30% split between businesses, students, and the military. While all five REITs own fairly well-diversified portfolios across the country, we note the geographic and quality focus of the five REITs below. The three largest REITs - Public Storage, CubeSmart, and Extra Space - operate relatively high-rent portfolios in primary markets, while Life Storage and National Storage Affiliates operate facilities with generally lower rents in secondary and tertiary markets.
Who paid the rent? While self-storage REITs were quiet when it came to providing pre-earnings updates, ultimately, nearly all current renters paid their April and May rents. With rent collection above 95%, self-storage demand has proven to be quiet "sticky," consistent with trends of the prior Financial Crisis. As the popular reality show Storage Wars has highlighted, rents are essentially "collateralized" by a renter's stored possessions, and unpaid rents typically result in the repossession and auction of the goods contained within the storage locker. During the Financial Crisis, self-storage occupancy levels declined roughly 2-3% compared to the 6-8% average declines seen in other more economically-sensitive REIT sectors, including retail, industrial, and office.
However, as we'll discuss in more detail below, rent collection may only tell part of the story, and we caution that there were some moderately unsettling developments below the surface that introduce near-term uncertainty. Leasing volumes slowed considerably during the pandemic with a nearly 25% plunge in "move-in" rates during April even as self-storage facilities were considered "essential" businesses in essentially all U.S. jurisdictions. This decline in move-in rates, however, was mostly offset by a 15% decline in move-out rates, but the net direction of the "pent-up" activity remains a question mark. Storage REITs have again been quiet in providing updates, and with limited visibility or precedent, the next quarter's earnings results will be especially consequential.
As we'll discuss throughout this report, while near-term risks remain, our longer-term outlook remains favorable as we see opportunity amid the recent industry struggles as these REITs can begin to assert their competitive advantage in access to equity capital to fuel accretive external growth. The storage industry remains a highly fragmented industry, and these five REITs own roughly 20% of the total square footage in the US, 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.
Importantly, self-storage REITs operate with some of the most well-capitalized balance sheets across the real estate sector. As discussed in our recent report, Cheap REITs Get Cheaper, consistent with the persistently "winning factors" exhibited by the REIT sector over the last decade discussed in the prior report, higher-yielding, higher-leveraged, and "inexpensive" REITs have declined nearly twice as much as their lower-yielding, lower-leveraged, and more "expensive" counterparts. All five consumer-focused storage REITs operate with debt ratios that are below the REIT sector average of 43%, led by Public Storage, which operates with perhaps the most conservative balance sheet within the REIT sector with one of the few, coveted "A-rated" long-term bonds.
Additionally, the operating efficiency of the self-storage business is second to none in the real estate sector, commanding some of the highest NOI margins in the real estate space at over 70% while requiring minimal ongoing capital expenditures to maintain the facilities. A double-edged sword for asset owners, including REITs, the ease and efficiency at which operators can enter the market have resulted in a wave of speculative supply growth coming online over the last half-decade, a large chunk of which has come from developers with limited previous experience in the self-storage business. For this reason, we believe that acquisition and consolidation opportunities should be plentiful over the next decade for these storage REITs as the weaker operators are "shaken out" by potential dislocations resulting from the coronavirus crisis.
On the demand side, self-storage units are the "Hotel California" of the real estate sector: once you're checked in, "you can never leave." Nearly half of renters stay longer than two years, and about a quarter rent for at least a decade. Demand is driven by growth in household formations and underlying change within these households. Boomer downsizing, an increase in moving rates, and demographic-driven demand in key age cohorts have been demand catalysts that we expect to continue well into the 2020s, regardless of the course of the pandemic. Often viewed as an extension of the residential sector due to high correlations with multifamily and single-family fundamentals, self-storage REITs comprise roughly 5-8% of the broad-based "Core" REIT ETFs and also comprise roughly 3-4% of the Hoya Capital Housing 100 Index, which tracks the performance of the United States housing industry.
The darlings of the REIT sector from 2010 through 2015, self-storage REITs were perhaps the best-kept secret within the REIT investment community in the immediate post-recession period, but have fallen on tougher times over the past half-decade as developers and new operators have flocked to the sector and added new supply at a furious rate, weakening fundamentals and resulting in relatively disappointing performance. A little "change" may have been exactly what the doctor ordered for the self-storage REIT sector, which has proven to be an unexpected leader this year following a half-decade of lukewarm performance. Self-storage REITs are lower by just 8.4% so far in 2020 compared to the 17.7% decline on the broad-based commercial Real Estate ETF (VNQ) and the 1.7% decline by the S&P 500 ETF (SPY).
Low balance sheet leverage, high operating margins, and limited economic sensitivity of rental demand have been in-demand attributes within the REIT sector amid a time of immense economic uncertainty. Below, we present a framework for analyzing the REIT property sectors based on their direct exposure to the anticipated COVID-19 effects as well as their general sensitivity to a potential recession and impact from lower interest rates. Within the COVID-19 sensitivity chart, we note that storage REITs are among the four sectors with the lowest direct COVID-19 sensitivity (along with cell tower, data center, and industrial REITs), and are also one of the least sensitive sectors to general economic conditions. As mentioned above, self-storage demand has proven to be quite "sticky" even during the depths of the prior Financial Crisis.
Performance this year has followed a near-perfect correlation with market capitalization - and balance sheet quality - as sector stalwart Public Storage has led the way, followed by Extra Space and CubeSmart. Over the last five years, however, small-cap National Storage - which focuses on secondary and tertiary markets which have seen more muted supply growth - has been the top-performer in the sector with average annualized returns of 16.6% since 2016, followed by Extra Space with average returns of 5.5%. The other four REITs in the sector, however, have trailed the 4.8% average annualized total returns of the NAREIT All Equity REIT index.
Investors willing to forego some upside potential but capture a relatively steady stream of income have the option of going the "preferred route." Two of the six REITs offer preferred securities, tracked in our new iREIT Preferred REIT & Bond Tracker. These include a suite of thirteen preferred issues from Public Storage (PSA.PB, PSA.PC, PSA.PD, PSA.PE, PSA.PF, PSA.PG, PSA.PI, PSA.PW, PSA.PX) and one from National Storage (NSA.PA). All of the issues are standard cumulative redeemable preferred securities that currently trade with an average yield of roughly 5.1% and trade at modest premiums to par value. These fourteen issues are roughly flat on the year, outperforming their respective common issues by an average of 7.8% in 2020.
Heading into the coronavirus outbreak, self-storage fundamentals were among the softest in the REIT sector but showing some signs of stabilization. Charting the same-store NOI performance against the broader REIT average, we note the meteoric rise and subsequent sharp dip in NOI growth in the self-storage sector. After producing REIT-leading NOI growth above 10% in late 2016, same-store NOI growth has underperformed the REIT sector average in two straight years. While the self-storage REIT sector has historically shown a high degree of correlation with the residential REIT sector, the performance of the two categories has diverged since 2018 with residential REITs now seeing some of the strongest same-store NOI growth across the real estate sector.
Record levels of self-storage construction spending from 2015 to 2019 - translating into a roughly 25-30% rise in total self-storage supply over this time - has led to intense price competition among operators. The lack of new supply in the storage sector was the driving force behind the sector's significant outperformance early in the decade, and while supply growth appears to have peaked in 2018, deliveries are expected to remain elevated through at least 2020. A slowdown in self-storage supply growth should be expected during and in the aftermath of the COVID-19 outbreak by suppressing speculative development, which may help to alleviate some more acute oversupply issues in the self-storage sector over the next several years.
As mentioned, there may be opportunity amid this period of disruption for the self-storage REIT sector, which has historically been more active acquirers among REIT sectors. External growth via acquisitions has explained a significant percentage of FFO growth over the last decade, and with minimal same-store organic growth, investors will look to external growth to shoulder even more of the "growth burden" in the early part of the next decade. On recent earnings calls, even before the coronavirus pandemic, REIT executives had discussed the expectation that many of the weaker operators and more opportunistic developers will be willing sellers over the next few years given the intense competition, allowing these REITs to scoop up assets at attractive valuations. Self-storage REITs acquired $2.3 billion in net assets over the last twelve months, one of the few REIT sectors that remain "net buyers."
Core FFO growth, which rose by more than 13% from 2013 to 2016, continues to decelerate across the sector, but the extent of the decline is not as significant as once feared. Boosted by this accretive external growth, core FFO rose by 2.6% in 2019 and was expected to rise by roughly 2% in 2020 based on pre-COVID-19 guidance. Before withdrawing guidance, National Storage and Life Storage projected the strongest rates of growth, reflecting the limited supply pressures in lower-tier markets. 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.
Once exclusive to the realm of "Growth REIT" investors, self-storage REITs have increasingly caught the attention of yield-oriented investors as dividend yields have swelled, while valuations have come back towards the REIT sector average. Relative to other REIT sectors, self-storage valuations are roughly in line with the REIT sector average based on forward AFFO. Storage REITs pay out roughly 70% of their available cash flow, leaving a decent-sized buffer before potentially being required to cut dividends in the event of a significant coronavirus-related negative impact.
Speaking of dividend cuts, self-storage REITs have been one of the only property sectors that have been completely unscathed by the wave of coronavirus dividend cuts. We have now tracked 58 equity REITs - primarily retail and lodging REITs - out of our universe of 165 that have now announced a cut or suspension of their common dividend, roughly a third of the equity REIT sector. Absent a second-wave of widespread economic lockdown, we believe that the five consumer-focused self-storage REITs can continue to pay dividends at current levels, but payout levels will likely be further stretched.
Within the sector, among the consumer-focused storage REITs, we note that CubeSmart pays the highest yield at 4.7%, followed by National Storage and Life Storage at 4.6% and 4.4%, respectively. Business storage REIT Iron Mountain pays a yield of 9.4% but does so with a payout ratio at-or-above 100%, and thus is at the highest risk of a dividend reduction. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding and higher-leveraged counterparts.
Below, we outline five reasons why investors are bullish on self-storage REITs.
Below, we outline the reasons why investors are bearish on self-storage REITs.
Storage demand is driven by "change", and there's been no shortage of that amid the pandemic. Self-storage REITs have delivered notable outperformance relative to other real estate sectors this year. With rent collection above 95%, self-storage demand has proven to be quite "sticky," consistent with the depths of the prior Financial Crisis. Essentially an extension of the residential sector - perhaps the most "essential" of all property sectors - the demographic-driven demand in multifamily and single-family housing bode well for a continued recovery into the 2020s once supply growth returns to "normal" levels a trend that should be accelerated by the pandemic.
Near-term risks remain, however, as leasing volumes slowed considerably amid the pandemic with a plunge in "move-in" rates offset by similarly low "move-out" rates. With limited visibility or precedent, the next quarter's earnings results will be especially consequential and potentially volatile. Our longer-term outlook remains favorable as we see opportunity amid the recent industry struggles as these REITs can begin to assert their competitive advantage in access to equity capital to fuel accretive external growth.
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High Yield • Dividend Growth • Income. Visit www.HoyaCapital.com for more information and important disclosures. Hoya Capital Research is an affiliate of Hoya Capital Real Estate ("Hoya Capital"), a research-focused Registered Investment Advisor headquartered in Rowayton, Connecticut. Founded with a mission to make real estate more accessible to all investors, Hoya Capital specializes in managing institutional and individual portfolios of publicly traded real estate securities, focused on delivering sustainable income, diversification, and attractive total returns.
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