2023-03-12 07:58:30 ET
Summary
- Self-storage REITs have seen tremendous growth fuelled by urbanization and smaller living spaces.
- But this trend has turned during Covid as people started leaving big legacy cities and moved south in search of a larger and cheaper living space.
- Because of this self-storage has likely peaked making investment unattractive at the current valuation.
Dear readers/followers,
I've recently covered many different types of REITs here on Seeking Alpha, but I've been hesitant to look at self-storage REITs. The reason is that I don't believe they make particularly good investments at this time. Still I think it's worth sharing my thoughts here.
The performance of self-storage facilities has mainly been driven by urbanization. This makes sense. As more people move to a city where the standard is to live in an apartment (rather than a house), it is very likely that they won't have enough space in their apartment for all of their stuff, hence enhancing demand for self-storage. Moreover with rising real estate prices, some people were forced to down-size and developers responded by building smaller units and now the average apartment size of an apartment is the smallest its ever been. Again, this fuelled more demand for self-storage.
While the growth has been impressive, I feel that the self-storage market has peaked and I expect it to underperform going forward. Why do I think that? During covid many people fled big cities to buy a larger space (ideally a house). This great migration made headlines as people mainly moved to the Sunbelt region and although I don't think legacy markets are dead (in fact I'm quite bullish on some undervalued residential REITs in the area), it seems that the trend is here to stay. It is clear that this is exactly the opposite of what self-storage needs to grow. At the moment urbanization is slowing and people are moving from mature legacy markets elsewhere (mainly South). The trend is only reinforced by work-from-home. That's why I am not rushing to invest in the space, especially because the companies aren't exactly cheap and I expect vacancies to increase over the next few years. With that said, I think it's still worthwhile to have at look CubeSmart ( CUBE ) and keep an eye on it in case it becomes cheap.
Basics
CubeSmart owns and operates 1,279 self-storage properties across the US making it the third biggest player on the market with a 4.4% market share. The market is actually quite fragmented with the largest company Public Storage accounting for less than 10% of the market and the top 5 players accounting for under 30%. This makes the market quite competitive which could be a headwind if demand slows.
The properties are primarily located in densely populated mature markets, mainly on the East Coast, with 33% of NOI generated between Boston and DC. What's important is that CubeSmart focuses on markets with strong demographics. In particular it has higher average population density and higher median household income in a 3 mile radius from its properties than any of its peer, which gives it a unique advantage. Their focus on mature markets and stronger demographics could help the company be less volatile through the economic cycle, because the higher income demographic will be more resilient. Unfortunately for CubeSmart the higher income demography will probably also be more likely to have the option of moving out of the city and into a larger space if they want to. The portfolio is further diversified through operation of third party assets in secondary markets (light blue in the map below).
Financials
CubeSmart has seen tremendous growth over the last decade as it tripped the number of locations and grew FFO from just $0.60 per share in 2011 to $2.53 per share in 2022. In 2022 the company recorded good results as their adjusted FFO increased by 20% YoY driven primarily by same-store NOI increase of 16.7%. Remember, these are very short lease contracts, which enables the company to increase rents very fast in an inflationary environment, but it also makes it very easy for tenants to leave.
Regarding occupancy I want to point out that same store occupancy averaged 94% in 2022 (compared to 94.6% in 2021), that doesn't seem like a major drop but if we look closer we'll see that occupancy continually declined through the year, reaching only 92.1% by the end of 2022, which somewhat confirms my thesis of lower demand going forward. Even management has been open about the fact that double digit same-store revenue growth won't be sustainable and expects a further drop in occupancy to 91.4% in 2023 with more modest revenue growth of 4-5%, expecting FFO between $2.64 and $2.71 per share. The forecast is conservative, which I like, somewhat confirming my worries that the best might be behind us and the sector could underperform in terms of growth.
To be fair, it's not all bad, the company does have a pretty good balance sheet. It is BBB-rated and has virtually no debt maturities until November 2025 which I always like to see. It also enjoys a very low weighted average interest rate of 2.98%, with 98% of the debt fixed. Net debt/EBITDA has improved every year over the past 5 years and currently stands at a healthy level of 4.3x. Frankly, there is nothing to dislike about the balance sheet.
The company also pays a reliable dividend which was recently increased by 14% and currently yields 4.3%. With a payout ratio of 77% the dividend should be safe going forward, though I expect it to grow by 5% at most over the next few years.
Valuation
Ok so we've seen that financially the company is in a good shape, but growth will definitely slow going forward and over the medium to long-term the occupancy could be under pressure if urbanization growth remains low. That's fine, but only if the valuation reflects this, so let's have a look.
CubeSmart currently trades at 17.8x FFO which is basically in line with its historical average. This is also in line with Public Storage (17.5x), Extra Space Storage (18.2x) and Life Storage (17.9x). Some people argue that the average should be revised downward because interest rates are now higher. What I would mostly argue though is that it should be revised downward because of lower growth prospects going forward. It is very unlikely that the company will be able to achieve the same level of growth that it has over the last decade and therefore I think it's fair to value at a lower multiple of say 15x.
With an NOI of $716 Million the company trades at an implied cap rate of 5.4%. According to Savills the spread between cap rates on self-storage and 10-year treasuries tend to average around 3%. With 10-year yields currently at 3.7% a fair market cap rate for self-storage would be around 6.7%. That's quite a bit higher than the 5.4% cap rate being priced in by the market. In fact if the market were to price the share at an implied cap rate of 6.7% the price would drop by 24% to $35 per share which is around the October low.
To sum, I think it's clear that CubeSmart is not undervalued here. If anything it is overvalued, based on a relative multiple and especially based on an implied cap rate of just 5.4%. For comparison, that's the same implied cap rate that prime residential REITs such as MAA, EQR and AVB trade at and I can tell you that that's not normal. Residential space almost always has significantly lower cap rates than commercial real estate, including self-storage.
That's why I rate CubeSmart as a " HOLD" here at $45.60 per share and would only consider buying the stock around its October low. This is supported by both types of valuation, both of which suggest at least a 20% downside to fair value.
There could even be an interesting play here to short the self-storage sector and long a more promising sector such as residential or net lease REITs, but personally I'm not big on shorting equities.
For further details see:
CubeSmart: Good Company In An Overvalued Sector