2023-04-05 11:19:28 ET
Summary
- After the decision to buy Life Storage, Extra Space Storage is about to become the biggest self-storage REIT in the United States.
- The company offers the perfect mix between growth and value, thanks to its superior business model that should allow for outperforming growth in the years ahead.
- While industry headwinds are mounting, self-storage remains in a relatively good spot. I'm adding EXR shares on weakness.
Introduction
It's time to talk about Extra Space Storage (EXR) . This company has been one of my favorite REITs and dividend growth stocks for a very long time. In November of last year, I finally added the stock to my dividend growth portfolio. Last month, I aggressively added to that position, making it a top-seven position.
In this article, I will walk you through that decision, and some interesting developments, including deteriorating commercial real estate fundamentals, the accepted deal to acquire Life Storage (LSI), and Raymond James' bullish comments, which perfectly confirm my own view on EXR.
So, let's get to it!
What's Happening To Commercial Real Estate?
Extra Space Storage is currently down 29% from its all-time high. This excludes dividends and is in line with the decline of the Vanguard Real Estate ETF ( VNQ ), which I use as a benchmark for the REIT sector.
In general, REITs are perceived as safe investments. While that is correct, REITs do suffer in times of high inflation. Especially in this environment, REITs are being pressured by high inflation causing pricing issues, rising rates making it harder to finance deals, and economic uncertainty adding to demand worries.
Wells Fargo just came out with a rather bearish report on commercial real estate ("CRE"), which highlighted tightening credit conditions and the looming economic downturn.
According to the bank:
In our view, more restrictive lending boosts the odds the economy enters a recession. While there is likely to be significant variance among property types and across geographies, commercial real estate fundamentals will likely deteriorate if a downturn comes to fruition, as we currently anticipate.
As soon as the Fed began to raise interest rates, the standards for tightening started to become more stringent. As a result, the current landing conditions are similar to those seen during the pandemic and the Great Financial Crisis.
Needless to say, tightening credit standards in an industry dependent on affordable financing is something that will always have negative consequences.
Hence, it's no surprise that delinquency rates in the CRE sector are starting to gain upside momentum.
An economic downturn likely would weigh heavily on CRE fundamentals, which could push up delinquency rates and distressed asset sales higher. These factors could also drag on property valuations, which already look to be declining from the elevated levels reached recently.
While the market is softening, industrial real estate remains in a rather good spot. Please note that self-storage is a part of industrial real estate. According to the report, the industrial market is expected to face some challenges due to a slowdown and pullback in consumer goods spending. However, the demand for industrial properties is likely to receive support from supply chain reconfiguration and e-commerce integration, leading to structural changes in the industry.
Related to this, despite reduced consumer spending, retail vacancy rates are expected to remain low due to the slow pace of new retail construction after the rise of e-commerce. This trend is expected to support rent growth in the retail space over the next few years. However, certain retail segments, such as regional malls, are likely to face continued pressure in the current market.
When we zoom in a bit, we find evidence that self-storage is indeed in a rather good place. According to the March Yardi Matrix Self Storage report :
Street rates were flat in February as growth patterns are returning to normal. Despite the tempering of rate growth, the industry is in a comfortable position as the spring leasing season approaches. Although fundamentals softened slightly in the fourth quarter owing to normal seasonal patterns and some customers balking at increasing rates, demand is strong and occupancy remains ahead of where it normally is this time of year.
Moreover, one major headwind in the industry is new supply. After all, self-storage is a segment with low entry barriers. In February, new supply under construction accounts for 3.6% of completed inventory. While this number remains resilient, expectations are that elevated construction costs and economic headwinds will pressure new supply in both 2024 and 2025, which is great news for existing providers of self-storage.
In other words, while CRE is in an increasingly tough spot, I am happy with my decision to focus on self-storage assets. While I have plans to diversify, I currently only own self-storage REITs.
Furthermore, I solely buy companies with stellar balance sheets and superior operations that will (hopefully) protect me against mayhem if the Fed goes too far in its fight against inflation.
That's the perfect segway to discuss Extra Space Storage.
Why I'm Buying So Much EXR
I owned EXR before the pandemic in a different portfolio. When I started my dividend growth portfolio in 2020, EXR was not included. That was a mistake, as it outperformed Public Storage ( PSA ), which I did include in my portfolio.
That said, I used the current stock market weakness to buy EXR. I started buying in November, and I recently added, lowering my average buying price to roughly $158.
Before buying Life Storage, EXR was the second-largest self-storage REIT in the United States, operating more than 165 million square feet of storage assets. This translates to 1.6 million units, which are managed by 4,500 employees in 41 states.
The company has excelled at operating these assets, as it has outperformed all peers when it comes to historical funds from operations growth.
This allowed the company to generate high shareholder returns.
In addition to beating all of its peers on a total return basis, the company's dividend is yielding 4.1%. Its dividend has been hiked for 12 consecutive years. The average annual dividend growth rate of the past five years is 14.4%.
Now, the company made an interesting move. It acquired Life Storage after Public Storage failed to come up with a compelling bid for the company a few months ago. Life Storage has been on my list for years, as I am a huge fan of the company's focus on turning self-storage assets into next-gen mini-warehousing assets.
Life Storage has been focused on third-party logistics since 2021, launching a number of micro-fulfillment centers. This is one of the reasons why I am such a big fan of self-storage, as the right management can turn it into so much more than just self-storage assets.
Self-storage assets often enjoy fantastic strategic locations close to city centers, making them viable for a wide number of operations related to logistics - like last-mile transportation.
Interestingly enough, LSI will now be a part of my portfolio, just not as a standalone company.
The $12.7 billion all-stock deal creates a combined company with an enterprise value of $47 billion. LSI shareholders get 0.895 EXR shares for each LSI common stock they own. The deal is expected to close in the second half of this year.
LSI shareholders will own 35% of the new company, which will continue to be named Extra Space Storage. Kenneth Woolley will remain Chairman of the board. Joseph Margolis will remain CEO. However, the board will expand to 12 seats, allowing LSI to nominate three directors.
The combined company will own more than 3,500 stores in 43 states. The number of stores in growth markets like Florida and Texas increases by 5%.
This deal will dethrone Public Storage as the nation's largest self-storage operator, giving the new EXR a 13% market share - beating PSA by 300 basis points.
Moreover, this deal creates the sixth largest REIT included in MSCI US REIT Index. And while the lower occupancy rate and margins of LSI lower the average numbers as well, this combination covers two of the best and most consistent performers in the self-storage industry. Since 2010, both EXR and LSI have dominated same-store revenue growth and FFO per share growth.
Furthermore, the fact that LSI is less profitable than EXR opens up new opportunities. It's one of the reasons why EXR bought LSI. It knew it could quickly generate synergies.
EXR aims to generate at least $100 million of run-rate annual operating synergies, which includes improving operating expenses and boosting operating revenue.
As the overview below shows, EXR is a superior self-storage operator. If it applies its system to LSI assets, it should be able to generate synergies on a consistent basis.
As mentioned in the introduction of this article, Raymond James also recognized these benefits. Its analysts came out with a Strong Buy rating, noting that $100 million in annual synergies is more than expected.
It's also fair to say that EXR has a history of successful M&A projects. Over the past five years, the company invested more than $8 billion in M&A, buying Storage USA ($2.3 billion), SmartStop ($1.4 billion), and Storage Express ($590 million), among others.
On top of this, it matters that EXR hasn't bought a company with too much leverage. In other words, I am not ending up with a riskier position in my portfolio.
The combined company will have a net leverage ratio of 5.0x EBITDA, which is the result of the all-stock deal (no additional borrowing was needed). The fixed charge coverage ratio drops a bit to 5.4x. This ratio shows how well a business can pay its fixed expenses, including mandatory debt payments and interest.
Moreover, both EXR and LSI have a BBB credit rating.
When it comes to debt maturities, LSI does not add short-term maturities to the new company. It has no major maturities until 2026. In general, the new company will have to refinance less than 20% of its debt before 2026, which buys it a lot of time in this high-rate environment.
Based on this context, the company now has a number of benefits.
- Acquisition costs are reduced as fixed costs are spread over a larger number of stores.
- Its larger footprint allows for more efficient marketing.
- Both companies are technology leaders with platforms that allow for efficient operations and growth outside of traditional self-storage operations.
- EXR's customer acquisition model is scalable, allowing prospective customers to benefit from a larger inventory and more locations.
- No new debt was created in the deal.
- The balance sheet remains healthy.
On top of that, I believe that EXR shares remain attractively valued at 19x FFO. That isn't cheap as it is above the sector median of 12.6x FFO. However, EXR is in a better spot to generate growth. It also operates in a strong industry.
That said, because of economic challenges, I don't know if EXR is bottoming at current prices. The stock could move lower to $120 if the Fed is forced to continue its hiking cycle and/or if CRE starts to weaken further.
FINVIZ
As I have anticipated economic weakness since last year, I'm fine with this situation. My strategy is to buy high-quality stocks on weakness. While I have bought EXR quite aggressively, I will keep buying if this stock moves lower.
Takeaway
In this article, we discussed one of my favorite dividend growth stocks. I believe that EXR is the perfect mix between growth and value, as it comes with a dividend yield of more than 4% and high long-term dividend growth backed by a fantastic business model.
I also believe that buying LSI was a smart move. The combined company is powerful and in a fantastic spot to keep outperforming its peers, despite its massive size.
Moreover, while credit conditions are worsening, causing REIT share prices to fall, self-storage remains in a good spot. Rents are stable, new supply growth is easing, and demand remains strong.
While none of this is a guarantee that EXR shares cannot fall any further, it gives me some comfort, as I believe that the economy isn't out of the woods yet.
In other words, my strategy remains to keep adding on weakness until the economy bottoms. Once that happens, we'll likely get high outperforming capital gains on top of our dividend.
For further details see:
Why Extra Space Storage Is One Of My Favorite Dividend Stocks