2023-06-05 06:30:00 ET
Summary
- National Storage Affiliates Trust has experienced rapid growth through 2022, but its future growth depends on market adjustments to new capital market realities.
- NSA currently offers a dividend yield above 6%, with the potential for growth in the future, although the timing is uncertain.
- NSA is a reasonable choice for investors seeking income at the 6% level and not concerned about near-term growth, with the PRO structure providing strong dividend security.
A chat-room friend of mine has been enthused about National Storage Affiliates Trust ( NSA ) for the past few years as reported FFO/sh has grown rapidly. Not so much now, though, as that growth has come to a screeching halt. Guidance for 2023 is for flat FFO/sh.
But from 2017 through 2022, FFO/sh grew at a 17% CAGR. That is a ridiculous number; REITs should not be able to do that.
My curiosity led me to try to see how they did it. This article tells that story and considers implications for the future.
Before we start, let me note that my knowledge of self-storage is less deep than that of some other sectors. The standard picture is that there are many private facilities that could be brought into REITs:
National Storage Affiliates
But it has seemed to me that there is not much potential for a moat in the storage sector. Supply concerns kept me out before the pandemic. And I for one did not foresee the great year the sector had after it.
The Big Picture on National Storage
Before we get to the complexities, here is how National Storage presented themselves in November 2022:
The division of equity and debt is near the average for REITs. The ratio of Net Debt to EBITDA is not terribly high for a fairly new REIT, and the 5.0x interest coverage ratio gives them room if they need to absorb rising rates. But they show only $650M available on their credit revolver, which is a bit low for a REIT of their size.
The BBB+ rating is by Kroll, and its meaning is not as clear as a rating by one of the big three. It rather reminds me of graduate school applications I used to see by students who had gotten an A in Physics at a lower-tier state school. That A said many positive things about them, but provided no information about whether the student could succeed in a Physics graduate program at a top university. It seems hard to know what BBB+ from Kroll really means.
There are good and bad aspects of their balance sheet. The bad news is that their (unswapped) variable rate debt is 18% of the total as of Q1 2023. The good news is that the debt is 91% unsecured and they have swapped a lot of what was variable rate to fixed rate.
Their debt maturity ladder also has good and bad aspects. The good is that they have managed to exploit that credit rating by making private placements of debt out beyond 10 years recently.
The bad as of last November was the relatively large debt due in 2023 and 2024. But between then and March 31, they pushed the revolver to 2027 and cleared the 2023 debt.
So now all that remains before 2025 is $275M in 2024. Based on what they just accomplished, that does seem manageable. My preference would still be for them to work further ahead. It would be safer.
Returning to the Capital Structure graphic, the breakdown of the equity is more intriguing. Many REITs issue OP units as a tool for tax-effective transfer of property into the REIT by private owners. But having that fraction be as large as 24% is not common.
And then there are the SP units and the “PROs” — what the heck are they? Let’s look at that.
Growing with the PROs
National Storage began with 100 properties and now, ten years later, is at 1,100. But they did not grow mainly by buying up properties.
Instead they have grown mainly by adding 11 PROs, which stands for Participating Regional Operators . My take on this follows (again I welcome additional information).
Suppose you have built up a self-storage business with something like 100 properties. But it represents all your wealth and beyond that your children have no interest in the business.
Financially you should find a way to diversify where your wealth is held. Generationally you would like to find a way to leave legacy value to inheritors. But you are not ready to retire, yet.
One option, and not only in storage, is to do a sale-leaseback to take capital out of the business and keep running it. But that leaves you with larger expenses and the risk of losing the business at a time not of your choosing.
Oh boy, does National Storage have a deal for you. In simple terms, they will buy your business and backstop it, while you will continue to operate it as long as you like. On top of that, they will provide resources and tools that enable you to operate more profitably.
There is fine print, so to speak. This graphic illustrates the structure:
The left section shows the debt and equity involved in the transaction. Debt is 50% and Equity from the REIT is 25%. The owner is given OP Units and SP Units amounting to 25% of the purchase price.
A strong benefit of this deal is that the owner gets a smaller, more secure regular payout and an incentivized payout above that. In reading the waterfall plot, consider the items in dark blue and green to lead to the net Cash Available for Distribution, or CAD. In this case it is $3M out of an NOI of $6.3M; the ratio is typical for REITs.
The priorities for the CAD are shown, in order, to the right of the green bars. First there is a “Preferred Allocation” of 6% of invested equity to the common shares and the OP units.
Note that this is specified relative to equity, not CAD. The next priority is to pay up to 6% of invested equity to the SP units. The “SP units” stands for Subordinated Performance Units.
Above that full 6% payout, excess cashflow is split 50/50 among all the units. This structure provides incentive to the PROs to increase profits. It also insulates returns to common equity from fluctuations in performance by the PROs, no matter what the cause.
One example, likely right now a concern for their PROs, is the big green bar in the graphic showing Debt Service. As it grows, the returns to the SP units get reduced as soon as any excess cash flow is gone.
But NSA has little floating-rate debt and only a small fraction of the fixed-rate debt matures each year. This will limit but not eliminate the hit to the PROs from increasing interest costs.
On the whole, this structure with the PROs is very friendly to the common shareholders. It is not as friendly to the PROs but apparently has been an acceptable deal in the context discussed above.
Eventually the PROs retire and National Storage absorbs their businesses into the corporate operations. This is at present a minority of total assets, providing operating profits and NOI growth like those one sees for many REITs.
The Cash Flows
National Storage spends a large fraction of Cash from Operations, or CfO, in three places. These are dividends to common stock and OP units, preferred-stock dividends, and payments to SP Units (and Joint Ventures).
Here the TIKR entry for “Other Financing Activities” is almost entirely such payments. The total fraction paid out to all three places is on average 83%. On the scale of their past property acquisitions, the retained earnings are tiny as you can see here:
RP Drake
In this graphic the net retained earnings are in green, newly issued stock is in red, and new debt is in gray. The blue bars show the acquisitions.
What you see here is an acquisition model that is nearly 100% driven by issuing equity. Such models break if equity gets too expensive, as we discuss next.
The NSA Business Model
The business model here for growth differs a bit from what we usually see from REITs. The Debt Service gets covered by the NOI, but does not directly enter the return on new equity.
The return on new equity is 6%, and maybe more if things go well. Things have to go really badly to reduce this, although that could happen.
Specifically, reduced revenue would have to wipe enough CAD that the preferred returns were underfunded. In the model of the graphic above this would take a drop of 22% in revenues. Revenues for self-storage REITs fell less than that during the Great Recession.
The dividend yield has averaged around 4% since the IPO, making it accretive to shareholder value to issue new equity and bring on board new PROs. In round numbers, that rate lets you sell $100M of stock that costs $4M in dividends but produces at least $6M of returns, shared by all shareholders.
But this year the yield is up near 6%, implying that further dilution will be neutral at best.
National Storage did recently raise some equity by issuing preferred shares with a 6.1% yield. That seems unlikely to make shareholders any gains. And indeed, the guidance midpoint for FFO/sh is $2.82, flat from last year.
The guided midpoint for acquisitions is $300M, down by half from 2022. That may keep the pipeline of acquisitions flowing, but that is about it.
What needs to happen is the usual story across real estate these days. The hope seems to be that interest rates will go down soon enough and the stock markets will go up and everybody can get back to where they were before.
But maybe that will not happen. For business to become possible with current capital markets, cap rates would have to increase. Adapting this into the PRO model would mean that all the rates of return would increase too.
To my mind an easing of interest rates is likely. And it is likely but not guaranteed that the stock markets will respond. So perhaps National Storage will get back to growth before too many quarters go by.
My view here is also that National Storage made the initial mistake that we see so often amongst REITs. They set their payouts too high at their IPO.
This was an ideal choice for the 2010s but left growth completely dependent on the whims of the market. Had they set the payout at, say 4%, that would have left enough retained earnings to keep growing even now.
But the 2020s may not get back to the conditions of the 2010s. Then National Storage will produce very little growth of FFO/sh going forward until market conditions change as just discussed.
A related risk is that other potential sources of capital do not have the constraint that their cost of equity is determined in the public markets. National Storage and all REITs compete agains other potential owners of properties that are available. When the public markets shut REITs that operate like National Storage out of the acquisition markets, private sources of capital can still choose to transact.
Valuation
This story makes valuation uncertain. If the markets did not ever let National Storage grow further beyond rent increases, then NSA would be more or less fairly priced now. At the other limit, if the markets return to supporting the growth rates of the 2010s and stayed there, then NSA would have a value of more than twice the present price.
Just for fun, I did an intermediate model with 3% growth of FFO/sh for six years followed by 10% growth for six years (the 6&6 Model). The model repeated this four times to go out to 48 years. This will be much closer to what reality will be than either of the limiting cases just mentioned.
On that basis, you get this plot of fair FFO multiple vs discount rate:
For a range of discount rates from 10% to 12%, which seems to me a good guess at what might happen, one gets multiples from 16x to 22x. From that one might say that 19x is a sensible estimate of fair value, uncertain by about± 15%.
That 19x is about 50% upside from todays FFO multiple of 13x. Considering how short-sighted the market often is, you would seem likely to get the low end near 16x during low-growth periods. This would be nearly 25% upside from here.
When high growth next arrives, that upside from here might run to 75%. But it is hard to know when that might happen.
Takeaways
National Storage grew rapidly through 2022, reflecting both their initial small size and their aggressive use of new stock to drive growth.
But at this point adding a new 100-unit PRO is less than 10% growth in gross property. And the stock market has priced them out of the path of using new stock.
This year FFO/sh will be flat. Future growth depends entirely on how and when the markets adjust to the new realities in the capital markets, whatever those turn out to be. So it would be very speculative to buy NSA and think that there will soon be a return to past valuations.
But today NSA is paying a dividend above 6%. And that will grow, sometime.
When that dividend growth will occur is also uncertain. This is both for reasons above and because National Storage might sensibly decide to move toward a lower payout ratio so they have more capital to support growth with issuing stock.
I see NSA stock as a reasonable choice for an investor seeking income at the 6% level and not concerned about near-term growth. Notably the PRO structure strongly protects the ability of NSA to pay the current dividend. It would take an unprecedented collapse of the storage sector to threaten it.
There are also quite a few other REITs in the ballpark of the same yield and with clearer prospects for dividend growth. Their dividend security may be less, though.
So whether you might want to own NSA depends on how much you care about dividend security and how much diversification you want. I see it as a reasonable component of a REIT portfolio targeting 5% yield and moderate growth.
For further details see:
A Look At National Storage Affiliates