PSA - Public Storage: The Preferred Dividends Are Well Covered

2023-11-03 10:30:00 ET

Summary

• We're focusing on buying fixed rate preferred securities in anticipation of lower interest rates.
• Public Storage's Q3 results include just a few days of consolidation of Simply Self Storage and positive delta on interest income.
• The Series H preferred shares of Public Storage are trading at a discount and offer a reliable preferred dividend yield.

Introduction

As it looks like the interest rates on the financial markets may be topping out at the current levels, I'm accelerating my focus on buying fixed rate preferred securities in anticipation of lower rates. And I have two reasons for that: Not only do I want to lock in the higher cash flows, the interest rate decreases also should result in capital gains as lower required returns should boost the market value of fixed income securities.

I always liked to keep an eye on the financial results of Public Storage ( PSA ). As a leader in the self storage space, this REIT combines a strong financial performance with a robust balance sheet. This combination makes the preferred shares quite attractive from a risk/reward point of view.

A closer look at the Q3 results

Before diving into the Q3 results, it's important to note the acquisition of Simply Self Storage only closed on Sept. 13 and this had a two-fold impact on Public Storage’s financial results. First of all, the current quarter will be the first full quarter that will include the consolidation of the Simply results. During Q3, only $5.8M in NOI was contributed by Simply .

Secondly, Public Storage issued the acquisition-related debt on the same day it announced the acquisition. In hindsight, the timing couldn’t have been any better as the interest rates on the financial markets increased by approximately 100 bp throughout the summer. This also had the remarkable result that Public Storage was actually making money on its unemployed cash as there was a positive delta of approximately 3 bp between the cost of the debt issued in July and the interest income generated on the cash.

When looking at REITs, the reported net income is relatively unimportant and the FFO result is more representative to figure out how attractive a REIT is.

As you can see in the image above, the starting point of the FFO calculation indeed is the reported net income attributable to the shareholders of Public Storage where after a bunch of corrections are being made like the almost quarter of a billion in depreciation and amortization expenses. This results in a total FFO attributable to the common shares of $807M and a core result of $763M after deducting the $48M FX gain.

Looking at the per-share performance, the FFO came in at $4.58 per share while the core FFO was $4.33 per share after taking the adjustments into account. The REIT did not issue any shares to fund the acquisition of Simply Self Storage so the total share count remained relatively unchanged at just over 176M shares.

The REIT has now also published an updated guidance for 2023. It has now increased its anticipated same store revenue growth while narrowing down its expense growth. This should now result in a total core FFO of $16.60-16.85 per share, a noticeable increase from the $16.40-16.80 guidance published earlier this year. This means the core FFO per share will increase by 4.3-5.8% compared to last year and that is obviously good news for the common shareholders.

The Series H preferred shares are now trading at a substantial discount to par

While there for sure is something to be said for a long position in the common shares, I'm keeping an eye on Public Storage’s financial results to keep close tabs on the risk/reward level of the preferred shares.

I tend to focus on two elements: The preferred dividend coverage ratio and the asset coverage ratio.

The dividend coverage ratio is pretty easy to establish. We know the REIT is now guiding for a full-year core FFO of $16.60 per share which means it expects a core FFO of just over $2.9B. This already includes the preferred dividend payments which will total about $195M this year. This indeed means the core FFO before making the preferred dividend payments is approximately $3.1B and this implies Public Storage needs less than 7% of its core FFO to cover the preferred dividends. Or in other words, the underlying core FFO is almost 16 times higher than what’s required to cover the preferred dividends. An excellent ratio by any standards. Even looking at the Funds Available for Distribution (shown below) there are no questions about the strength of the cash flows and the ability of Public Storage to cover its preferred dividends.

Secondly, I like to have a look at the balance sheet. As you can see below, there's a total of $10.1B in equity of which about $9.7B is tangible equity. The total value of the preferred equity is $4.35B which means there's about $5.35B in common equity which ranks junior to the preferred equity.

But there’s more than meets the eye here. While the book value of the assets is just $17.8B, the fair value is likely substantially higher as the REIT will generate about $2.8B per year in NOI. Looking at the book value of the income-generating assets, the book value of those assets represents just about seven times the NOI which is pretty low. If you would apply an NOI multiple of 10, the fair value of the assets is likely about $10B higher than the book value and this also means the total amount of implied junior equity is likely closer to $15B.

As you can see above, Public Storage has a lot of different series of preferred shares outstanding, and the REIT was smart enough to issue fixed rate preferreds. Given the current cost of capital, the preferred shares are cheap equity for Public Storage and even if/when interest rates fall again, only the more expensive issues will be called.

I wanted to focus on the Series H of the preferred shares which are trading with ( PSA.PR.H ) as ticker symbol. That series of preferred equity was issued in 2019 and still has a relatively high preferred dividend rate. In fact, the 5.6% preferred dividend rate is the highest of all outstanding preferred shares. This also means that if Public Storage starts to call preferred shares again, it will likely retire the series with the most expensive cost of capital first. The Series H can be called from March 2024 on, and are currently trading at just under $23 per share, which is a discount of just over 8% to the par value of $25 per share.

The fact this specific preferred share is trading at a discount to par also means the preferred dividend yield based on the current share price of $22.96 (the closing price as of last Wednesday) is approximately 6.1%.

Investment thesis

Given the strong preferred dividend coverage ratio and the robust asset coverage ratio, I'm charmed by the preferred shares issued by Public Storage. While a 6.1% preferred yield certainly isn’t the highest in the REIT landscape, I think the preferred dividend is reliable and when the interest rates on the financial markets start to decrease, the Series H are likely the first ones to get called. This means that the yield to call could potentially be very interesting: if the Series H would be called in two years from now, the total yield to call would be around 10%.

I haven’t decided yet which series of preferred shares I’d like to pursue and I will likely add a mix of the Series H and another preferred security with a lower dividend rate to my portfolio.

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