VNQ - Sell Public Storage Buy Big Yellow Instead

2023-03-07 08:05:00 ET

Summary

• Public Storage has been very rewarding in the past.
• But the future is likely to be very different.
• I highlight a better alternative: Big Yellow Group.

What was the best performing real estate investment ( VNQ ) over the last 30 years in the US?

You may be surprised to hear that it was self-storage:

Public Storage ( PSA ), ExtraSpace Storage ( EXR ), Life Storage ( LSI ), and others have truly earned extraordinary returns.

They earned 18.8% average annual returns and outperformed all other REIT sectors while also experiencing the least volatility.

If you had invested $100,000 in the US self-storage REITs, you would have turned it into $12,441,144 – a 124x without any additional contributions. You could have done potentially even better if you had managed to cherry-pick the best performers in the peer group.

That's truly fascinating when you think about it.

Self-storage REITs were so rewarding because of three main reasons:

• Above average internal growth: Scale and professional management make a very big difference in the self-storage business. REITs were able to acquire properties from unsophisticated operators and materially improved their operations to grow same property NOI. This includes the implementation of revenue optimization technologies, nationwide advertising campaigns, and a clear branding/marketing strategy to better target potential customers. Buying under-managed properties that weren't branded allowed these REITs to rapidly grow revenue with limited incremental capex.

• Above average external growth: REITs were able to also develop their own properties to meet the growing demand for self-storage space and the returns on development projects were exceptionally high, sometimes reaching even double-digit yields. Yet, the properties themselves would sell at much lower cap rates. The spreads that REITs enjoyed on these investments were very significant and they resulted in rapid external growth, which came in addition to the already strong internal growth prospects.

• Below average risk: Self-storage properties are notoriously resilient to recessions because people will often downsize their residence to save cost and rent storage space for the extra stuff, and similarly, businesses may downsize their office or even their warehouse and also resort to temporarily renting storage space. As a result, self-storage properties may not suffer as much during recessions, leading to even faster growth over a full cycle. To give you an example, self-storage REITs were the only REITs to post a positive return in 2008.

Combined together, all these factors led to exceptionally strong risk-adjusted returns over the past decades. This may lead you to wonder:

Why don't we then own any self-storage REIT in the US?

And the answer is simple: I fear that these past returns aren't indicative of their future potential. The issue is that these high returns aren't a secret anymore and they have attracted a lot of capital over the years. New REITs have emerged and real estate developers have built properties on every busy street corner of the nation. I have been driving around Miami over the past few days and it feels as if they are Public Storage facilities all over the place.

Moreover, most properties have been optimized by now and I fear that most development opportunities have also been exhausted. This is also happening at a time when the newer generations are increasingly interested in buying experiences over things, and the sharing economy makes it often a lot cheaper and convenient to rent things like an RV, a boat, or anything else that would typically store at such a property.

To be clear, this does not mean that self-storage REITs will perform poorly going forward. I am sure that some opportunities remain for growth in this sector. But the next 20 years in the US likely won't resemble the last 20 years and this is why I wouldn't buy REITs like Public Storage today.

However, I think that opportunities are abundant elsewhere in the world and our Top Pick in Europe is the Big Yellow Group (BYG / [[BYLOF]]).

Today, the self-storage concept is still relatively new in the UK and EU, but it is rapidly growing in popularity because people live in even smaller units and they need self-storage for the same reasons as in the US: divorce, death of a close relative, moving, growing a small business, etc.

Moreover, increasingly many people are also starting to work remotely from home for many days each week and need to free up space for a home office.

So demand is now growing rapidly, but today there is still less than 1 square foot of self-storage space per capita in the UK compared to about 10 in the US.

I believe that this provides an exceptional opportunity for European self-storage REITs to replicate the strong returns of US self-storage REITs over the coming decades.

They are developing new properties, earning huge spreads over their cost of capital, all while also acquiring existing properties and improving their operations.

Big Yellow has been executing this strategy in the UK since 2000 and it has earned 16% average annual returns, and that's despite suffering greatly in the aftermath of the great financial crisis. Adjusted for that, the average annual returns would have likely surpassed 20% per year:

And today, it is still just getting started as it is about 20x smaller than its largest US peer, Public Storage.

It still hasn't even expanded outside of the UK because that's where people know its brand and where it earns the best returns, but eventually it will, and the EU market is even more unpenetrated.

So here we have a great investment story and despite that, we are not paying much for it.

Big Yellow is down 33% year-to-date and in addition to that, the British Pound is also down an additional 10% relative to the US Dollar. It is down so much because the market has soured on growth stocks and European stocks dropped even more than US stocks due to the war in Ukraine.

I think that this has resulted in an exceptional opportunity to accumulate shares of Big Yellow at a discounted valuation because the long-term story hasn't changed and even the near-term outlook remains solid.

Despite the drop in its share price, Big Yellow has actually performed very well. Just recently, it released its 6-months results, and here are some of the highlights:

• It grew its FFO per share by 14%.
• It hiked its dividend by another 8%.
• It hiked rents by about 10%.

That's in addition to strong growth in the preceding months. Year-to-date: Big Yellow has grown its FFO per share and its dividend by 24% in 2022. Here is its track record of growth:

Since 2004, it has grown its FFO per share at a compounded annual average of 14%, and we think that it can keep growing at such a rapid pace for a long time to come. Today, they have 11 development sites, most of which are in London, and they have a projected initial yield of nearly 9%, which is huge even relative to the now higher interest rates.

Today, the shares are priced at 20x FFO and it offers a near 4% dividend yield. That may not sound low to a value REIT investor who's used to paying much lower multiples, but remember that Big Yellow is not your average REIT. It typically sells at closer to 30x FFO and a dividend yield in the 2-3% range.

I have held Big Yellow for many years, I have always bought the dips when it dropped, and I have never been disappointed in the long run.

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