PSA - Public Storage: Why 'Low Risk' REITs Are The Most Vulnerable Today

2023-04-18 11:24:58 ET

Summary

• The "stagflationary" environment has caused the bond-stock correlation to rise, limiting the "hedge potential" of most low-risk or defensive assets.
• Like bonds, lower-risk REITs carry the most significant exposure to the rise in interest rates due to the elevated "duration risk" from low capitalization rate properties.
• Self-storage REITs like PSA are at high devaluation risk because an increase in capitalization rates disproportionately harms its net asset value.
• Public Storage may also face declines in operating income due to the potential overdevelopment of self-storage centers since 2020, negatively impacting monthly rental rates.
• PSA may be a hidden short opportunity with a target price of $230-$240, given the estimated change to its net asset value.

Over the past year, increased volatility in financial markets and lackluster economic data have caused a renewal of interest in low-risk investments. Many investors have flocked toward those assets with the best performance during recessionary periods such as 2008. Problematically, while there are similarities between today's economic situation and 2008, crucial differences make today's environment relatively unique. Most global Western economies are in a stagflationary environment characterized by moderately high inflation and low-to-negative economic growth. Such a scenario has not occurred in any recessions over the past ~45 years, meaning very few investors today know the historical dynamics stagflation can bring to financial markets.

During a typical credit-driven recession, economic demand falls firmly below supply, causing inflation to fall (often becoming negative) as unemployment rises. Interest rates decline accordingly, causing low-risk bonds and bond-like investments to increase in value - usually offsetting stock declines. That is not occurring today. Last year was the worst year on record for the Treasury bond market despite declining stocks and economic growth. Although inflation has moderated slightly, the correlation between long-term Treasury bonds ( TLT ) and stocks ( SPY ) remains exceptionally high. The current rolling 36-month SPY, TLT correlation is ~0.5, meaning bonds and stocks move together after many decades of tight negative correlation.

This change significantly impacts financial market performance and is crucial for investors (who wish to preserve capital) to understand. Since "low-risk" Treasury bonds are positively correlated to "high-risk" stocks, virtually all "bond-like" investments are also more positively correlated to stocks. This includes most "defensive" sectors such as utilities, consumer staples, and low-risk REITs. However, since many investors believe these sectors are necessarily anti-cyclical, they have outperformed over the past year despite significant declines in the net asset value of their underlying assets. As recently seen in banks, even "off the book" declines in net asset values can eventually wreak havoc on companies when they look to sell assets.

In my view, commercial real estate is likely the next related domino to fall, as the rise in interest rates causes property capitalization rates to increase. Notably, "high-risk" properties with naturally high capitalization rates stemming from economic exposure (hotels, retail, etc.) carry the lowest exposure to this particular risk factor. However, lowest-risk REITs with naturally low capitalization rates carry the highest risk because a rise in "cap rates" has a more significant "duration impact" on their asset values.

This issue was mirrored in the bond market last year when the "investment grade" corporate bond market ( LQD ) fell by ~20% while the "junk bond" market ETF ( JNK ) only declined by ~15%. Since "low risk" LQD's yield was well-below "high risk" JNK's, the rise in interest rates had a more considerable negative impact on the asset value of LQD than JNK. This devaluation shift lagged in commercial properties since they're less liquid but have begun to catch up early this year. Accordingly, investors may benefit from avoiding REITs with naturally low capitalization rates. I believe particular popular "defensive" REITs, such as Public Storage ( PSA ), are due to abnormally large declines over the rest of 2023.

Supply Overgrowth May Hamper PSA's Sales

Public storage properties are fantastic for many reasons. For one, most people put their junk in public storage but never take it out, giving these companies high recurring revenue and low customer acquisition costs. Secondly, self-storage units have meager operating costs, promoting high internal rates of return. Lastly, demand for self-storage may increase during recessions as people look to downsize. This factor positively impacted PSA in 2008 and 2020 but depends on the degree to which downsizing occurs - today's low availability of small homes could limit this factor in the future.

Additionally, the supply of self-storage units has risen dramatically over the past decade due to their high profitability and demand. Following the 2020-2021 spike, the monthly rental cost of self-storage declines as the "storage shortage" ends. Self-storage producer price index data lags behind the recent surveys showing declining self-storage rents. Historically, PSA's value, revenue per share, and the PPI of self-storage operators are very closely correlated. See below:

The decline in self-storage rents may cause PSA's sales per share to decline slightly over the coming year, potentially offsetting any recessionary benefit. That said, it remains the case that Public Storage's revenue and income are largely recession-resistant. Additionally, I believe it is generally unlikely that storage rents will fall back to pre-COVID levels unless supply growth continues for too long. Public storage's capital expenditure level is back at its high historical range, implying we may see excess supply growth in the self-storage sector by next year.

Public Storage's Devaluation Has Hardly Begun

The potential decline in PSA's quarterly sales and income is a lower risk factor than its expected significant net asset value decline. Since self-storage properties are resilient, they sell at excessively low capitalization rates of around 5.1% at the end of 2021 (the general trough to capitalization rates). Since 2021, there has been a slight rise in all commercial property capitalization rates. Capitalization rates are intimately tied to interest rates, specifically real interest rates, because property rents are generally expected to keep up with inflation. Real interest rates hit an all-time low in 2021 due to excessive QE, causing capitalization rates to decline and boosting commercial property values. Capitalization rates are starting to rise faster as transaction volumes plummet .

Although it takes time for capitalization rates to track real interest rates (since commercial property transactions take many months to accomplish), I believe cap rates will eventually rise by 2% across the board (given the 2% increase in real interest rates since the 2021 minimum). This change would bring the self-storage industry's average capitalization rate back near its typical level before the 2013 decline in real interest rates (triggered by a deflationary fall in commodity prices that ended abruptly in 2020). As such, I will give PSA a forward valuation estimate based on a 6.5-7% capitalization rate range, discounting it from the market average due to its lower risk profile.

Last year, PSA had an operating income of $2.19B and $888M in depreciation, bringing its net operating income to ~3.08B. Based on a 6.5-7% capitalization rate range, my estimated fair value of PSA's operational assets is $44B to $47B . The company ended last quarter with an additional ~$1.27B in other tangible assets against $7.39B in liabilities and $4.35B in preferred equity, creating a net negative ~$10.5B difference between its estimated total asset value and net asset value (or estimated market common stock equity value). Thus, based on my estimated capitalization rate increase, my fair-value estimate for PSA's common stock is $33.5B - $36.5B. This NAV estimate implies PSA is trading at a 45% premium and would need to decline by ~32% to a share price of $200 to be fairly valued today.

Realistically, the fair-value capitalization rate of PSA's assets may be below the self-storage market average because of its higher quality profile. Valuing the company at a 6% "fair value" cap rate, its estimated property value rises to $51B. Subtracting $10.5B in net liabilities and preferreds, its estimated common equity value would be ~$40.8B, ~20% below its current market capitalization, giving us a target price of $233. In my view, PSA may decline closer to the $200 range. Still, a $233 target seems most realistic since its assets are higher quality than self-storage (allowing for a 50 bps to 1% capitalization rate discount - or "quality" property value premium). However, PSA's prospects may fare better or worse depending on changes to its NOI (based on self-storage rental rates) and the success of its current investments.

The Bottom Line

Overall, I am quite bearish on PSA and believe it will eventually decline in value as low transaction volumes in the commercial property market accelerate increases in capitalization rates. Importantly, PSA may continue to trade at a significant premium to its NAV due to investor interest in its "recession resilience"; however, the opposite may also occur due to the likely decline in its rental rates. Capitalization rates may also not rise to the extent that I expect if real interest rates decline and remain low. This could occur in a recessionary scenario, mainly if significant QE efforts are made again. That said, as long as the Federal Reserve is fighting inflation, I do not believe we will see real interest rates fall back into negative territory. PSA is currently trading at an implied capitalization rate of ~5%, so it would be roughly fairly valued today if real interest rates fall from ~1-1.5% (today's level) to 0-0.5% under a recessionary dynamic.

In a best-case scenario, PSA may not decline in value if a recession causes real interest rates to reverse and self-storage rents to stabilize. In a more likely scenario, though, I believe PSA may fall to around $230-$250 as a rise in capitalization rates and a slight decline in its rental revenue (per share) cause its valuation premium to erode. In a worst-case scenario, PSA could decline below $200 - requiring real interest rates to remain historically high (boosting capitalization rates - hampering property values) with a more significant decline in self-storage rents due to overdevelopment.

Since PSA has low volatility and rarely deviates too significantly from its NAV (as do most REITs), it could be a short opportunity today. The primary bearish catalyst is the closing lag between bond prices and commercial property values, creating temporary overvaluation of lower-risk commercial properties. In my view, the largest risk to short-selling PSA is a restart to QE and recession that promotes its "best case" outcome; however, even in that scenario, I do not believe PSA will rise above its ~$400 peak. Very few are short-selling PSA, so its borrow cost is near zero . Its option implied volatility is near the median level , so put options may be a decent way to bet against the stock with a defined structure.

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