PSA - Extra Space Storage: Need For Space

Summary

• Extra Space Storage has been a beneficiary of the self-storage boom, which already started pre-pandemic.
• I like the business from a long-term positioning, but a reversal from a post-pandemic trend might be seen, given high rental growth in recent times and economic slowdown.
• While Extra Space Storage shares are down substantially, I fear that today is not necessarily a great entry point just yet.

Shares of Extra Space Storage Inc. ( EXR ) is a real estate investment trust ("REIT") which has been nearly 50 years in existence, founded in 1977. Following a period of growth, the company went public in 2004, and through some larger deals as well as organic growth, the company has grown a formidable portfolio.

Extra Space has been a huge beneficiary of the pandemic boom as growth might rapidly come down, leaving questions on what is fair value.

The Portfolio

The name of the REIT already indicates what the business entails, that of providing extra storage space. The specialty of these assets, which involve many small properties leased out to consumers (among others), means that ownership of these properties entails the running of the operations as well.

The company was involved with 2,327 properties as of the third quarter of 2022, roughly half of which were fully owned and operated. This is accompanied by some joint-venture assets and some assets for which the company provides the management.

The company's portfolio includes 175 million square feet, comprised out of 1.6 million units, suggesting an average unit size of just over 100 square feet. The many units mean that the business is not just a REIT, but entails operations as well, hence some 4,000 employees appear on the pay list, with nationwide coverage being a reality as properties are located in some 41 states. Many of these assets are located in metropolitan area, including New York, Los Angeles, San Francisco, Washington DC, Atlanta, and Boston, among others.

The company competes against the likes of Public Storage ( PSA ) which is about the same size, and smaller peers like Life Storage, Inc. ( LSI ) and CubeSmart ( CUBE ) in the so-called self-storage space. Given the many properties and units, the occupancy rates have come in a bit lower than major industrial and logistics peers, but a 95% occupancy rate is quite decent. Rental growth has been quite strong coming out of the pandemic, as two-year retention rates have risen to nearly 50%. This is a bit low in terms of real estate but high for this category based on historical standards.

Given the fact that this type of real estate is quite human/labor-intensive, digitalization is key with regard to websites, apps, online leasing, customer accounts, entrance, etc., as scale makes the difference in this area.

In terms of the financial performance of the situation, it looks the following: the company reported total assets of $10.5 billion in 2021, primarily consisting of real estate assets, either direct in full ownership or through a JV. The leverage ratio was a bit high, with just $3.8 billion in equity (including some minority interests) financing these assets. Fortunately, the company has 75% of debt hedged with fixed rates with weighted maturities of 5.5 years.

Revenues from these assets are quite high in relation to the valuation of the real state, with revenues posted at $1.6 billion, including $66 million in managed fees in a situation where the company is not the owner. All of this still translates into double-digit gross yields. Revenues furthermore include $170 million in tenant insurance. The costs to manage these properties are quite intensive, with half a billion dollars spent on property operations, tenant insurance, and general and administrative costs.

The company posted an operating profit of $975 million, after a $242 million deprecation charge but after a $141 million transaction gain as well. Interest expenses were relatively modest at $166 million, resulting in GAAP earnings of $827 million, equal to $6.19 per share.

The company posted adjusted (core) funds from operations at $974 million, or $6.91 per share based on 141 million shares outstanding, with these funds trending around $7.50 per share based on the fourth quarter performance. The company originally guided for 2022 funds from operations ("FFO") between $7.70 and $7.95 per share. Part of the growth comes from same-store sales growth (higher rents) as well as continued investments, totaling $1.3 billion in 2021.

2022 - So Far

The history of this REIT's performance is very strong. A $12 share price at the time of the IPO in 2004 was initially trading flat for quite a few years, but shares rose to the $100 mark in 2016, trading around that level ahead of the pandemic as well. Shares peaked in the $220s in December 2021 amidst strong demand and low-interest rates, with shares trading at roughly 30 times FFO.

The company started 2022 on a very strong note, with first quarter FFO up 34% to $2.01 per share, as the company hiked the dividend to $1.50 per share, for a 75% payout ratio. The FFO number rose to $2.13 per share in the second quarter and $2.21 per share in the third quarter. The company remains very aggressive with its growth of the portfolio, with net investments pegged at $1.5 billion this year, although Extra Space Storage Inc. has actually taken advantage of the high share price to issue some stock to finance this growth. Funds from operations are now seen at $8.30-$8.40 per share, with variable debt resulting in some higher interest expenses, offset by rental growth.

The balance sheet has grown to $11.8 billion, now financed with equity of $4.1 billion, for a relatively low equity ratio around 36%. These headwinds and concerns on the future have created quite a pullback in the shares, now back to $142, their lowest level over the past 52 weeks. With 142 million shares, the market valuation of $20.2 billion exceeds the book value by about $16 billion here!

This means that the roughly $11.8 billion in assets are really valued at $27.8 billion by the market, which feels a bit rich. At this rate, the business will generate $1.9 billion in revenues this year, with realistic earnings coming in around a billion dollars, after some depreciation charges as well. This still feels a bit rich in terms of the valuation, even as the $6 per share dividend starts to provide quite some comfort at a 4.2% yield, as the growth is still seen in the business.

What Now?

The truth is that the self-storage space might have been one of the REITs which has benefited the most from the pandemic, just like the larger industrial and logistics property sector, which has seen a retraction as well as of late. Contrary to other parts of real estate, this is really about land, good positions at valuable places, as the underlying real estate is not that valuable, or at least not of that high quality compared to other real estate categories.

With people cutting on spending and pressured by inflation, this might be considered a luxury with perhaps more items thrown out and subscriptions being canceled as the short-term leases, and already low renewal rates (compared to some other forms of real estate) pose a risk from that point of view.

While leverage is high from a balance sheet of view, Extra Space Storage Inc. equity still trades at a huge premium. This makes the leverage in relation to the market value relatively small, allowing for options to deleverage by issuing shares, or even halting growth. With Extra Space Storage Inc. shares down meaningfully from the highs, but still up a great deal from the start of the pandemic, I am performing a balancing act, seeing largely fair value as I am not enticed yet to buy the dip.

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