Within the vast Real Estate Investment Trust (REIT) sector, there is a subsector that, in my opinion, stands out for its high quality, and that is self-storage. In this article, we will delve into why these businesses possess attractive qualities as investments and why Extra Space Storage (NYSE:EXR) appears to be one of the best players to consider.
With interest rate increases during 2023, REITs were significantly affected because they often serve as bond proxies with high leverage. However, with the news that the Federal Reserve could potentially reduce interest rates in 2024, there is a possibility of a turnaround in these companies. This seems reasonable to me, leading me to assign a ‘buy‘ rating.
Extra Space Storage is a company that provides self-storage services. They are one of the largest self-storage operators in the United States. Extra Space Storage owns, operates, and manages numerous storage facilities across the country, offering a variety of storage unit sizes to individuals and businesses.
Customers can rent storage units on a month-to-month basis and use the space to store belongings such as furniture, clothing, documents, and other items. Extra Space Storage facilities typically provide security features such as surveillance cameras, gated access, and well-lit premises to ensure the safety of stored items.
Resilience to Difficult Economic Environments
Self-storage services demonstrate a robust resistance to macroeconomic crises due to the enduring demand driven by significant life events like relocation, downsizing, marriage, divorce, or family bereavement. These circumstances remain relevant irrespective of economic conditions, ensuring a consistent level of demand. Moreover, the flexibility offered through month-to-month rental agreements enhances customer convenience and reduces friction in comparison to committing to fixed-term leases, such as a year.
The resilience of self-storage services is exemplified by the performance of companies like Extra Space Storage, Public Storage and CubeSmart during the great crisis of 2008. In the period spanning from 2008 to 2009, there was a cumulative decrease in revenue by 2% in average. In other words, during the two years encompassing the most significant real estate crisis in recent history, a Real Estate Investment Trust encountered only a revenue reduction of 2%.
A Fragmented Growing Market
The self-storage market in the United States has witnessed substantial growth in recent years, with expectations of continued global expansion at mid-single-digit rates until at least 2029. This growth is primarily attributed to the steadily increasing population in the United States, where a larger population typically results in heightened demand for storage solutions. Urbanization and demographic shifts, particularly the trend of millennials relocating to cities for employment opportunities, contribute to the growing need for additional storage space.
Moreover, the prevailing culture of consumerism and the inclination to accumulate possessions further drive the demand for storage space. As individuals accumulate more belongings, the necessity for extra space to store items that no longer fit in their homes becomes apparent. With the rising cost of apartment rentals, individuals might opt for smaller living spaces, prompting the need for additional storage to accommodate possessions that cannot be housed in their new residences.
This heightened demand is reflected in the percentage of American households utilizing self-storage services, which has doubled from 5.5% two decades ago to nearly 11% at present.
The self-storage sector is characterized by a significant level of fragmentation, featuring numerous small and independent operators alongside a few larger national players. The industry’s relatively low barriers to entry make it accessible for entrepreneurs and local investors to initiate and manage their own facilities. Compared to some other real estate sectors, the development and operation of a self-storage facility typically demand less initial capital and expertise.
The sector’s major players include Public Storage, reporting $4.48 billion in revenue in the last twelve months, Extra Space Storage with $2.32 billion, CubeSmart with $1 billion, and National Storage with $860 million in revenue. Notably, U-Haul, originally a company focused on moving items transportation, has recently entered the lucrative self-storage segment. U-Haul is leveraging its extensive distribution network and brand power to tap into this market.
Despite the substantial revenues generated by the top five competitors in the self-storage industry, their market presence is relatively modest when considering the total square footage available for self-storage rental. These key players account for only 30 to 40% of the market share, leaving the remaining 60 to 70% distributed among numerous small competitors. This fragmentation makes smaller businesses attractive targets for mergers and acquisitions by larger players, contributing significantly to inorganic growth within the industry.
For instance, Public Storage has transparently disclosed the breakdown of its growth since 2019, revealing that approximately 18% of their growth has been achieved through acquisitions. This strategic approach allows larger companies to expand their market share, enhance their geographic presence, and capitalize on the fragmented nature of the self-storage market.
Key Ratios & Competitors
In the last decade, the company has experienced an annual revenue increase of 15%, and its Funds From Operations (FFO) margin has averaged 50%, demonstrating a slight expansion to 60% in recent years. However, this growth was interrupted during 2020 and continues into the current fiscal year, 2023. In the last year, the company announced the acquisition of Life Storage, a close competitor that generated $1 billion in revenue during FY2022. This amount represents 50% of the $1.96 billion generated by Extra Space Storage. We will consider this information later during the valuation process.
FFO serves as an ideal metric for analyzing REITs because it excludes certain one-off items, such as the sale or purchase of assets, which could distort purely operational profits from Net Income.
Notably, the company’s dividend per share has increased 17% annually over the last decade and the payout ratio with respect to FFO is almost 80%, so we can consider it a safe dividend.
Another relevant aspect is that although the company has consistently issued debt, its Debt to Equity ratio has averaged 150%, which is quite reasonable. Better yet, it has currently dropped to only 72%, thanks to the acquisition of Life Storage, significantly increasing the company’s assets.
To put these figures into context, let’s also examine the primary competitors of Extra Space Storage. The table below implies a visible correlation between a company’s scale and its Funds From Operations margin. This correlation may be attributed to economies of scale, where fixed costs like property management, administrative expenses, and marketing are distributed across a larger portfolio of properties. Consequently, this results in lower average costs per unit, contributing to improved Funds From Operations margins. This connection could clarify why smaller companies, such as National Storage, are keen on expanding rapidly and why Extra Space ventured to make such a large acquisition. It could considerably improve the company’s competitiveness in a market that has not yet found a clear dominating leader.
It’s important to note that the company is currently trading at a certain premium compared to its peers. In my opinion, this is justified because the company is the second-largest in scale, and the integration of Life Storage has not yet been fully reflected. Additionally, it is the least indebted and has shown to have one of the highest occupancy rates, although the rest of the companies have also performed quite well.
Regarding the dividend, National Storage currently boasts the highest dividend yield among its peers, offering a return of nearly 6%. However, it is important to note that it is also the company that allocates the majority of its Funds From Operations (FFO) to dividends. As previously mentioned, while the 80% FFO Payout Ratio percentage seems reasonable, assessing the sustainability of the dividend and the potential for future increases becomes crucial when determining the best company in the sector. It is pertinent to explore companies with a more sustainable dividend and greater capacity to enhance it through an increase in the Payout Ratio. Therefore, it is logical that the market demands a higher yield from companies with the highest Payout Ratios.
As mentioned earlier, during FY2022, Extra Space had almost $2 billion in revenue, and Life Storage had $1 billion. So, it would be logical for the company to generate $3 billion in revenue in the short term. The company also detailed that, excluding the impact of the merger with Life Storage, Funds From Operations could decrease between 3 and 5% this year, in part because the shares will increase to 179 million post-merger
Considering that the company would reach just over $3 billion in revenue by FY2024 and then grow at a historical 15%, thanks to the mix of organic and inorganic growth, maintaining its margins of 60%, the Payout Ratio returns to a healthy 75%, and we demand a Dividend Yield of 4.5%, the expected potential return, if we bought at the current price, would be almost 17% with dividends included.
This seems like an excellent return to me, considering that we are dealing with a company that made an important leap to become the second-largest in the sector and that has solid quality ratios.
While we’ve acknowledged the resilience of self-storage firms, it’s essential to understand that they are not completely impervious to economic challenges. In times of severe and prolonged economic downturns, individuals prioritize cost-cutting, and businesses may reduce operations, potentially affecting the demand for storage services.
Furthermore, an excess supply of storage facilities in specific markets can impact occupancy rates and rental prices. Therefore, even though self-storage is generally considered robust, its performance can still be influenced by broader economic conditions. With intense competition and limited differentiation among these services, a crisis could easily instigate a price war as companies compete to attract consumers with more economical options.
Extra Space seems to be one of the best companies in one of the most promising sectors for investment today. With the news that the Federal Reserve could potentially reduce interest rates in 2024, REITs could be among the major beneficiaries, just as they were among the most affected during the rate hike.
Furthermore, the current valuation is quite attractive, as it has not yet fully factored in the acquisition of Life Storage. This is understandable given the magnitude of such a significant move, but it seems to make sense to me. Considering all these factors, I believe assigning a ‘buy‘ rating is reasonable.
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