RIET - Storage Wars

2023-04-14 10:30:00 ET

Summary

• Storage REITs are the best-performing property sector this year after lagging in late 2022, lifted by surprisingly solid earnings results and a thawing of the previously icy-cold housing market.
• Storage demand is driven largely by housing activity – specifically, home sales and rental market turnover - and the recent moderation in mortgage rates has eased concern of a deepening housing recession.
• Despite declines in new lease rates, Storage REITs easily topped earnings expectations and provided an initial 2023 outlook calling for mid-single-digit earnings growth, buoyed by "sticky" rent growth on existing tenants.
• Storage Wars Intensify: After turning down a bid from Public Storage, Life Storage agreed to be acquired by Extra Space in a $12.4B deal that will form the largest storage REIT. Following PSA's failed bid, the takeout odds have increased for both National Storage and CubeSmart.
• Irrespective of potential mergers, we expect storage REITs to leverage their stellar balance sheets to scoop-up highly-levered upstarts seeking an exit. We continue to like the longer-term prospects given the 'stickiness' of demand, bulletproof balance sheets, low cap-ex needs, and impressive margin profile.

REIT Rankings: Self-Storage

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on April 12th.

Self-Storage REITs defied expectations to the upside as comprehensively as any real estate sector during the pandemic, delivering cumulative earnings growth of over 50% since 2019. After stumbling in late 2022, storage REITs are the best-performing property sector this year, lifted by surprisingly solid earnings results and a thawing of the previously icy-cold housing market. In the Hoya Capital Self-Storage REIT Index , we track the five major self-storage REITs, which account for roughly $100 billion in market value: Public Storage ( PSA ), Extra Space Storage ( EXR ), CubeSmart ( CUBE ), Life Storage ( LSI ), National Storage ( NSA ), along with micro-cap Global Self Storage ( SELF ).

There are roughly 50,000 self-storage facilities in the United States, and proximity to one's home is typically cited as the most important feature. One in ten US households rents a self-storage unit, and 70% of self-storage customers are residential while 30% are businesses. The self-storage industry remains fairly fragmented with these six REITs owning roughly 20% of the total square footage, but these REITs also provide third-party management services to another 5% of storage facilities. Revenue and expense management technology, brand value, and cost of capital have historically given these REITs a competitive advantage over private market competitors and smaller brands. The three largest REITs - Public Storage , CubeSmart , and Extra Space - operate relatively higher-rent portfolios in more primary markets, while Life Storage , National Storage , and Global Self Storage operate facilities with lower rents in secondary and tertiary markets.

Storage Wars Are Back: Week after rejecting an $11B acquisition bid from Public Storage - which is currently the largest storage REIT with roughly 3,000 facilities - Life Storage agreed last week to be acquired by Extra Space in a $12.4B all-stock deal that will combine the second and third largest storage REITs. The transaction will create the largest storage facility operator in the U.S. in terms of the number of locations, eclipsing Public Storage ( PSA ). The combined company will own roughly 3,500 self-storage facilities - including their third-party managed and JV portfolios - representing over 264 million square feet and serving over two million customers. Life Storage stockholders will receive 0.8950 shares of EXR share per share of LSI, representing a price of $145.82/share as of the prior day's close.

In the wake of Public Storage's failed bid for LSI, we believe that the takeout odds have increased for both National Storage and CubeSmart , but we see NSA as the more likely second choice for PSA given its similar Sunbelt-focus as LSI. Irrespective of potential mergers, we expect these REITs to be in "growth-mode" due to a combination of factors and foresee these REITs using their stellar balance sheets to scoop up smaller, over-levered players that are seeking an exit. Storage REITs had been fairly quiet on the acquisitions front since a buying spree in late 2021 which included a pair of deals from Public Storage - a $1.8B acquisition of ezStorage and a $1.5B acquisition of All Storage - along with CubeSmart's $1.7B acquisition of Storage West.

Importantly for their external growth prospects, self-storage REITs operate with some of the most well-capitalized balance sheets across the real estate sector. On average, self-storage REITs operate with debt ratios that are well below the REIT sector average of 20%, 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. CubeSmart , Life Storage , and Extra Space all hold investment-grade long-term bond ratings as well. Five of the six self-storage REITs operate with debt ratios below 30%. National Storage employs a more aggressive leverage profile, but the company was proactive in late 2022 in addressing its variable rate exposure.

Storage Demand Normalizing At Strong Levels

Stumbling into the coronavirus pandemic with challenged fundamentals and an outlook for near-zero growth amid oversupply challenges, self-storage demand came roaring back to life beginning in late 2020 as booming housing market activity amplified pre-existing demographic tailwinds to drive record occupancy levels and double-digit rent hikes. The Producer Price Index for self-storage facilities - which has historically exhibited a near-perfect correlation with rent growth - illustrates this incredible turnaround - along with the more recent moderation. Peaking last April with a record-high annual increase of 17.9%, the most recent PPI report for March showed a continued cool down in the annual rate of growth to 9.4% in March- but still at absolute levels that remain nearly 30% above the pre-pandemic baseline.

Self-storage demand is more closely-correlated with household moving rates than many presume - specifically home sales and rental turnover - a previously-underappreciated correlation that was on full display early in the pandemic as robust housing market activity from mid-2020 through mid-2022 fueled a corresponding boom in self-storage demand. This trend worked in the reverse in late 2022 amid a rate-driven housing cooldown that sent the pace of both New and Existing Home Sales to their lowest levels since 2011. Rental market turnover was similarly sluggish - dipping to the second-lowest rate ever recorded by RealPage. The recent moderation in mortgage rates has breathed some new life into the sluggish housing market, however, as mortgage-purchase applications increased for the fifth week in a row, and Redfin's Homebuyer Demand Index jumped to its highest level since last May.

Storage REITs hit 'rock bottom' of a multi-year downtrend early in the pandemic and were left for dead by many analysts and investors. Green shoots began to emerge by late 2020 and after these signs of strength were initially dismissed as a short-term blip, these REITs built on the rebound in each of the subsequent quarters. Searches on Google for "self-storage unit" - which has historically exhibited a strong correlation with occupancy rates - climbed to as high as 60% above 2019-levels in early 2022, but began to moderate alongside the housing cooldown by mid-2022. Search activity briefly fell below 2019 baseline levels last December, but since bottoming just before Christmas, search activity rebounded in February and March and remains around 30% above the pre-pandemic baseline.

Self-Storage REIT Earnings Analysis

As discussed in our Real Estate Earnings Recap , despite the moderation in new lease rates, storage REITs easily topped their prior guidance and provided an initial 2023 outlook calling for mid-single-digit earnings growth, buoyed by "sticky" rent growth on existing tenants. C ubeSmart ( CUBE ) was a notable upside standout, reporting that its full-year FFO increased by 19.9% in 2022 and sees FFO growth of another 5.7% in 2023, the highest in the storage sector. CUBE expects same-store revenue and growth of 5% for 2023 as strong pricing trends on renewals are expected to offset a decline in rental rates for new customers. Similar to ExtraSpace ( EXR ), CUBE reported a reacceleration in rent growth since bottoming in November. Elsewhere, Life Storage ( LSI ) reported sector-leading FFO growth of 28.4% in 2022 and sees another 5.2% growth at the midpoint of its 2023 outlook and provided a preliminary outlook for 2024 as well, noting that it expects "low double-digit FFO per share growth in 2024, with a midpoint of 11%."

National Storage ( NSA ) also reported solid results, noting that its full-year 2022 FFO rose 24.3% - matching its prior guidance - while its full-year NOI rose 14.9%, which was 40 basis points above its prior outlook. For NSA, which trades at discounted multiples to its larger peers after dipping nearly 50% in 2022, guidance calling for slightly positive FFO growth in 2023 was an upside surprise given its relatively high variable rate debt exposure, the majority of which was fixed during the quarter via an interest rate swap agreement. Public Storage ( PSA ) has been a laggard since the start of earnings season, however, after forecasting softer growth than its peers with a forecast calling for 3.1% same-store NOI growth and 3.3% FFO growth. Remarkably, since the end of 2019, Self-Storage REITs have delivered sector-leading same-store NOI growth of over 40% - more than 15 percentage points better than the next leading sectors, single family rentals and manufactured housing.

The relatively strong fourth-quarter results follow somewhat disappointing third-quarter results in which the focus was on rising expenses, a dip in occupancy rates, and commentary regarding softer customer demand. In Q3, three-of-five REITs upwardly revised their same-store expenses, driven by higher marketing spending and property taxes, but all five REITs reported full-year expenses that were below their prior guidance. Storage REITs ultimately recorded NOI growth of 17.7% for full-year 2022, which was driven a 14.2% average rise in realized rents, a nearly 200 basis point improvement in NOI margins, and offset by a roughly 200 basis point decrease in occupancy rates.

Recent occupancy rate updates provided by these REITs over the past two months have been largely consistent with earnings call commentary in which storage REIT executives indicated that Q4 was likely the "bottom" of the demand cooldown. Storage REITs recorded a relatively wider 290 basis point occupancy rate decline in Q4, bringing their average ending occupancy rate to 92.1% - the lowest since late 2019 - but the relative occupancy decline has eased to 130 basis points in Q1, which is actually in-line with the seasonal averages for Q1 from 2016-2019. Storage REIT occupancy rates typically peak in Q2 and bottom in Q4. During these recent updates, several REITs also provided reporting on "street rates" - effectively the market rental rate for new self-storage customers - which showed that new lease rates are lower by about 10% year-over-year in early 2023, a slight improvement from Q4.

Self-Storage REIT Performance

As noted above, Storage REITs are the best-performing property sector this year with the Hoya Capital Self-Storage REIT Index - a market-cap weighted benchmark - higher by 13.4% so far this year, significantly outpacing the flat returns from the broad-based Vanguard Real Estate ETF ( VNQ ) during this time and the 7.7% gains from the S&P 500 ETF ( SPY ). Despite the underperformance last year in which storage REITs declined 27%, Storage REITs are still the top-performing property sector since the end of 2019, propelled by robust gains of nearly 80% in 2021 and 13% in 2020.

Diving deeper into the company-level performance, Life Storage has posted the strongest returns this year at nearly 45% following its takeover by ExtraSpace . Elsewhere, CubeSmart has also posted very strong returns as it has closed the once-wide valuation gap with its larger peers, driven by several catalysts, including its addition to the S&P 400 and by outperformance in its critical NYC market. National Storage was hit the hardest in 2022 with a dip of over 45%, but has rebounded alongside the pullback in interest rates. Public Storage and Extra Space are each higher by about 9% so far this year while micro-cap Global Self Storage has advanced by about 6%.

Deeper Dive into Self-Storage Economics

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 Index , which tracks the performance of the US housing industry. Rent collection has remained essentially spotless throughout the pandemic, consistent with our predictions early in the pandemic in which we projected that collection rates should remain resilient because rents are essentially "collateralized" by a renter's stored possessions as unpaid rents result in the repossession and auction of the goods within the storage locker. 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 these REITs, the ease and efficiency at which operators can enter the market has resulted in a wave of speculative supply growth coming online over the last half-decade. Storage REITs indicated that supply growth is expected to be a headwind over the next several quarters, but generally expect new development to moderate later in 2023 as the effects of higher interest rates and macroeconomic uncertainty temper the development appetite. Construction spending data from the Census Bureau has indicated that the peak in development appears to have occurred in 2017 and declined by more than 10% in 2021, but soaring rents and record-high occupancy rates spurred a rebound in starts in 2022. Data from Yardi shows that Sunbelt markets are among the most active builders with Dallas, Phoenix, and Orlando among the top 5 markets for units under construction alongside New York and Los Angeles.

While Sunbelt markets are seeing elevated supply growth, these markets are also benefiting from significantly higher levels of demand growth. Per the annual Moving Report from U-Haul and newly-released Census data, Florida was the fastest-growing state in 2022 on a percentage basis with an annual population increase of 1.9% while Texas earned the top spot on an absolute basis with the addition of nearly a half-million new residents. These two states were also the top one-way U-Haul truck customers during 2022, ranking as the top growth states on the annual U-Haul Growth Index. On the flipside, California and Illinois recorded six-figure decreases in resident population. At the regional level, the South was the fastest-growing and the largest-gaining region last year, increasing by 1.1% while the West region recorded an annual increase of 0.2%. The Northeast and the Midwest regions, however, recorded population declines of -0.4% and -0.1% residents, respectively.

Self-Storage REIT Dividend Yield

Storage REITs were one of the only property sectors that went completely unscathed by the wave of coronavirus-related dividend cuts that swept across the REIT universe in 2020 and were among the leaders in dividend growth in 2021 and 2022 as well. Storage REITs pay an average dividend yield of 4.0% which is slightly below the market-cap-weighted REIT sector average of 3.9%. Self-storage REITs pay roughly 80% of their available cash flow.

Diving deeper into the sector, we note that the dividend yield ranges from a high of 5.66% from micro-cap Global Self-Storage and 5.15% from National Storage to a low of 3.32% from Life Storage . Notably, CubeSmart , National Storage , and Extra Space have been among the leaders in dividend growth across the REIT sector over the past five years with double-digit average annual dividend growth rates. All six REITs have hiked their dividends over the past year, led by a 50% dividend boost from Public Storage, which had previously held its dividend steady since 2016.

Takeaway: As Housing Goes, So Goes Storage REITs

Storage demand is driven largely by housing activity - specifically, home sales and rental market turnover- and the recent moderation in mortgage rates has eased concern of a deepening housing recession. Despite declines in new lease rates, Storage REITs easily topped earnings expectations and provided an initial 2023 outlook calling for mid-single-digit earnings growth. We continue to like the longer-term prospects for the storage sector given the 'stickiness' of demand, strong balance sheets, low cap-ex needs, and impressive operational track record. Accelerated by tighter financing conditions and softer fundamentals, external growth opportunities should be plentiful over the next several years as more high-levered private players seek an exit.

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