2023-11-10 12:43:35 ET
Summary
- Extra Space Storage has performed poorly this year, allowing investors to buy at attractive prices.
- Self-storage REITs offer steady income, resilience in economic downturns, low operating costs, scalability, and proximity to urban centers.
- Despite challenges, Extra Space Storage remains optimistic, with a strong balance sheet and a 5.5% dividend yield.
Introduction
Initially, I wanted to go with a different title. Something like 5.5%-Yielding Extra Space Storage Is My Favorite REIT . However, I used a similar title two months ago when I wrote my most recent article on the self-storage giant.
Over the past few quarters, I've often highlighted my strategy to find good stocks, start a position, and expand my position on weakness.
Extra Space Storage (EXR) has become the perfect example of that strategy, as it has performed very poorly this year, allowing me to keep buying at increasingly attractive prices.
EXR shares are currently down 44% from their all-time high, which includes dividends. This performance is way worse than the 31% drawdown of the Vanguard Real Estate ETF ( VNQ ).
Although I cannot make the case that a downtrend isn't justified due to pressure on consumers (lower expected storage growth), elevated rates (pressure on real estate earnings), and sticky inflation (making elevated rates on a prolonged basis more likely), we're dealing with what I consider to be one of the best REITs on the market.
In this article, I'll use its just-released quarterly earnings to explain why EXR has become my favorite REIT for both income and growth. We'll also dive into new self-storage developments and the benefits that come with investing in this industry.
So, let's get to it!
Despite Headwinds, I Like Self-Storage
Self-storage is my favorite REIT segment. Although it is much more cyclical than residential real estate, it does have a number of benefits.
Here are a few that come to mind:
- Steady Income : Self-storage REITs often generate consistent rental income, as people use storage facilities for both short-term and long-term needs.
- Resilience in Economic Downturns : The demand for storage space tends to remain relatively stable even during economic downturns, making self-storage REITs relatively resilient.
- Low Operating Costs : Self-storage facilities typically have lower operating costs compared to other types of real estate, contributing to potentially higher profit margins.
- Scalability : Self-storage REITs can easily scale their operations by acquiring or developing additional storage facilities, offering growth potential. This is very handy when major investors want to deploy large sums of cash.
- Proximity to Urban Centers : Last-mile logistics and micro warehousing facilities are strategically located near urban centers, enhancing accessibility and responsiveness to customer needs. I believe that self-storage will increasingly be used for these purposes.
These are the reasons EXR believes make self-storage a great investment:
Unfortunately, economic woes are pressuring self-storage operators.
According to the October self-storage report from Yardi (emphasis added):
Self storage continues to face a more challenging leasing environment created by the broader effects of the economy, causing a further weakening of street rates . Street rates fell month-over-month in September and year-over-year growth remained negative, as demand trends softened through the end of the third quarter. National home sales hit their lowest level since January, weighed down by the current high home prices and mortgage rates, as well as limited inventory . As one of the biggest demand drivers, the slowdown in the housing market is putting pressure on leasing .
The good news is that there are tailwinds.
According to the same report:
However, rental movement and the need for more space could potentially help offset the lack of home sales . Operators have also been able to rely on existing customer rent increases (ECRIs) to maintain revenue growth . While there is uncertainty over how fundamentals will perform in the last few months of the year, many operators remain cautiously optimistic, as the sector has historically stayed resilient during economic shifts.
This brings me to EXR, as there's a lot more to it than buying random self-storage operators.
I want self-storage with growth opportunities, a healthy balance sheet, juicy, well-covered dividends, and a great valuation.
Extra Space Storage Surprises Investors
EXR is my favorite REIT. It's also my worst investment.
Currently, I'm down 20% on EXR, excluding dividends.
While it bothers me a little bit that I could have bought so much lower, I do like the opportunity to average down, which is what my long-term investment strategy is all about.
And apparently, I'm not the only one.
After reporting its earnings, EXR shares have added more than 10%, making it one of the strongest short-term rallies in the post-Great Financial era.
With that in mind, EXR is now the largest self-storage operator after merging with Life Storage. It now has a 13.4% market share in a market that is still extremely fragmented, allowing for significant market share growth for many years and decades to come.
The combined company has close to 3,700 properties. Half of these are wholly owned/consolidated. 13% are joint ventures. 35% of these assets are managed. The non-owned assets come with benefits like higher-margin income and the opportunity to work on takeover deals down the road.
So far this year, the acquisition pace has slowed due to the merger, but third-party management remains active. In Q3, 49 new stores were added to the managed platform.
Year-to-date, excluding the merger, 151 stores were added, with steady bridge loan volume despite challenges in the interest rate environment.
The company's total assets cover 280 million square feet of self-storage, with a well-diversified footprint that doesn't have more than 17% exposure in any major market.
California, for example, which is a market a lot of readers want to avoid, accounts for 12% of rental income.
Moreover, both EXR and LSI have dominated the self-storage industry since 2009, generating peer-beating same-store revenue and core FFO (funds from operations).
Furthermore, the company is doing rather well in a challenging environment, which caused buyers to return.
The third quarter performance aligns with the company's expectations. Extra Space experienced a 1.9% same-store revenue increase, driven by a high average occupancy of 94.4%. That's down one point from 95.4% in the prior-year quarter.
Customer behavior remains positive, with a solid length of stay and acceptance of rate increases.
While revenue exceeded expectations, higher expenses, particularly property tax increases, offset the performance.
This resulted in a modest miss in same-store Net Operating Income ("NOI") but was offset by a beat in General and Administrative ("G&A"), leading to a Core Funds from Operations ("FFO") of $2.02.
This was down from $2.21 in the prior-year quarter.
While this core FFO decline is far from great news, it was expected, as analysts expected core FFO to come in $0.11 lower.
Furthermore, the merger is going smoothly.
The merger achieved the target G&A synergy run rate of $23 million. Property-level revenue synergies are initiated, with the expectation of reaching the total synergy run rate by 1Q24.
Short-term dilution from the merger is consistent with estimates.
Good Guidance
In light of 3Q23 numbers, CEO Margolis emphasized the durability of storage as an asset class during the earnings call.
External growth drivers are robust, and Margolis expresses confidence in the company's team and operating platform, foreseeing a bright future for Extra Space. This also includes construction headwinds that pressure new supply. That's beneficial for pricing.
While the forecast for the fourth quarter indicates that new customer rate improvement hasn't been strong enough to raise the high end of the same-store revenue guidance range, the steady existing customer performance led to an increase in the bottom end of the same-store revenue range by 25 basis points for the full year.
Furthermore, as I already briefly mentioned, the expense side experiences greater-than-expected pressure from property taxes, particularly in Georgia and Florida, along with significant increases in property insurance premiums.
The annual same-store expense guidance is updated to reflect actual expenses and a higher run rate for property taxes, resulting in a revised same-store expense range of 4% to 5% for the full year.
This tightens the same-store NOI range by 25 basis points. However, the bottom of the NOI guidance range was hiked by 25 basis points.
The core FFO range, considering short-term dilution from the merger and add-back for transaction and transition expenses, was tightened to $8.05 to $8.20 per share, maintaining the previous midpoint.
Given the circumstances, I'm very happy with this performance.
The company also maintains a top-tier balance sheet.
As a result of the merger, the company's credit rating was boosted to BBB+.
The company has a net leverage ratio of less than 5.0x (EBITDA), its interest coverage ratio is 4.5x, and its weighted average interest rate is 4.5%.
A Juicy Dividend & Attractive Valuation
Extra Space Storage pays a $1.62 per share per quarter dividend. This translates to a yield of 5.5%.
Before the post-earnings stock price surge, that number was north of 6%!
This year, the company is expected to generate $7.76 in adjusted FFO, which translates to an 84% payout ratio. While that number is somewhat elevated, it gives the company enough room to protect the dividend, even if the economy deteriorates further.
Over the past ten years, the dividend has grown by 17.2% per year - on average. Over the past five years, that number is 14.2%.
On February 16, the dividend was hiked by 8%.
Please note that the chart above does NOT indicate a dividend cut. The company broke up its dividend payment due to the LSI deal. The total dividend did NOT change.
With that said, the fact that the dividend is juicy is important. That's because expected growth rates are lower than what the company experienced during the pandemic and in the years after the Great Financial Crisis.
As we can see in the bottom part of the chart below, the company is expected to see 4% lower AFFO this year, followed by 3% growth in 2024 and 6% growth in 2025.
This is also great news for the valuation.
Using the chart above:
- EXR is trading at a blended P/AFFO ratio of 15.1x.
- Its multi-decade normalized AFFO multiple is 20.3x.
- A return to that valuation could result in a compounded total return of 24% per year through 2025. That number includes dividends and expected AFFO growth rates.
- This would give EXR a fair stock price target of $171, well above the current price of $118. The current consensus price target is $139 (not included in the chart above).
While I'm not going to promise that EXR will bottom and rise to $171 without any major interruptions, this data shows that the risk/reward has become very attractive.
Although elevated rates and sticky inflation are likely to keep a lid on REIT stock prices, I'm using weakness to add to my favorite positions, which include EXR at these prices.
I have little doubt that EXR will be one of my most successful long-term investments, with a high likelihood of prolonged dividend growth and outperforming capital gains.
As we can see above, despite the significant sell-off, EXR is still outperforming VNQ by a wide margin over the past ten years.
Takeaway
In a market challenged by economic headwinds, Extra Space Storage emerges as a compelling investment.
The recent merger with Life Storage positions it as the largest self-storage operator with a 13.4% market share, promising substantial growth using synergies and potential market share gains.
The company's resilient performance in Q3, with a 1.9% same-store revenue increase, reflects its stability in a tough environment.
Extra Space Storage remains optimistic, emphasizing the durability of storage as an asset class.
With a robust balance sheet, improved credit rating, and a 5.5% dividend yield, EXR presents an attractive opportunity.
Despite short-term challenges, the potential for prolonged dividend growth and capital gains makes EXR a cornerstone in my long-term investment strategy.
For further details see:
I'm Not Done Buying 5.5%-Yielding Extra Space Storage