Storage REITs: Locked-In And Sticky

REIT Rankings: Self-Storage

This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on October 5th.

Self-Storage REITs have defied expectations to the upside as comprehensively as any real estate sector since the start of the pandemic, delivering earnings growth of over 50% since 2019, and while several pandemic-fueled tailwinds are waning, we believe that the long-term outlook remains quite compelling and that the ‘stickiness’ of storage demand will become especially evident amid the broader housing market cooldown. In the Hoya Capital Self-Storage REIT Index, we track the five major self-storage REITs, which account for roughly $100 billion in market value: Public Storage (PSA), Extra Space Storage (EXR), CubeSmart (CUBE), Life Storage (LSI), National Storage (NSA), along with micro-cap Global Self Storage (SELF).

Storage demand is closely-correlated with housing market turnover – specifically home sales and rental turnover – and surging mortgage rates have had a “lock-in” effect among existing homeowners while also pricing-out new formations. The trends towards smaller homes and high-density urban markets reversed during the pandemic as households sought additional space and more at-home amenities in the new “hybrid” work environment, but affordability issues and soaring residential rents have again started to temper some of this demand. That said, the magnitude of the recent sell-off goes far beyond any reasonable scenario of near-term demand moderation, as storage demand is quite “sticky” with nearly half of renters staying longer than two years, and about a quarter of renters staying for at least a decade.

While the rate-driven slowdown in housing market activity is expected to temper incremental storage demand, other concurrent indicators have indicated demand strength in the face of stiffening macro headwinds. The Producer Price Index for self-storage facilities – which has historically exhibited a near-perfect correlation with rent growth – showed another brisk month-over-month gain of 2.2% in August, pushing the year-over-year advance to 16.1% – just below the record-high rate of 17.9% set in April. Notably, the two available months of Q3 data – July and August – showed an acceleration in rent growth with annualized growth averaging 22%, up from the 11% rate in Q2.

Meanwhile, searches on Google for “storage unit” remain at levels that are roughly 40% above pre-pandemic levels and essentially even with record-high levels last year. In a report last week, data firm Yardi noted that while self-storage “street rates” moderated from record-highs in August, “demand continues to be strong” driven by increased penetration rates among younger renting households. Yardi also noted that secondary markets experiencing rapid population growth continue to lead in street rate gains with Orlando, Raleigh, Nashville, Miami, Charlotte, and Dallas seeing the strongest growth.

Recent updates provided in early September were also consistent with the generally positive trends seen in PPI and search data – but did show a relatively more pronounced seasonal slowdown in August than these other metrics. Public Storage noted that move-in rates in July and August were signed at rates 5.5% higher than the same period in 2021, but occupancy rates trended back towards pre-pandemic levels. Similar trends were on display from the other five storage REITs as well and across these updates, occupancy rates ended August lower by roughly 250 basis points, on average, from record-high 2021 levels while year-over-year “street rates” ranged from a low of -5% from Life Storage to +10% from National Storage in August.

Storage REIT Earnings Recap

As discussed in our Real Estate Earnings Recap, self-storage REITs continue to ride one of the most impressive turnarounds in recent memory and posted yet another “beat and raise” quarter in the second quarter. Driven by record-high rent growth, historically high occupancy levels, and accretive external growth through acquisitions and development, storage REITs delivered FFO/share growth of 27.1% in 2021 – far exceeding the prior record-high of 16.3% in 2015 – and the updated outlook for 2022 calls for FFO growth of another 21.5% this year. Of note, storage REITs delivered the strongest upward FFO guidance revisions of any REIT sector in both Q1 and Q2 with average upward revisions of over 250 basis points in each quarter.

The upside standout of Q2 was CubeSmart, which significantly raised its full-year FFO and NOI outlook. Fueled by strong rent growth in its critical New York metro market, CUBE now projects full-year FFO growth of 18.0% – up 450 basis points from its prior outlook. Extra Space also reported impressive results, raising its full-year outlook for the third time this year and now sees FFO growth of 21.6% – up 330 basis points from its prior target – and NOI growth of 20.0% – up 350 basis points. Public Storage – the largest storage REIT – boosted its full-year FFO growth outlook by 120 basis points to 18.7%. Notably, PSA commented that “new customer demand through the summer leasing season has been exceptional… We have good pricing dynamics on both, move-ins and with existing customer rate increases, leading to the highest rent levels we have seen historically.”

The 17% increase in same-store NOI growth in the second quarter was driven by three factors: an 18.2% average rise in realized rents, a 440 basis point improvement in NOI margins, and a 20 basis point increase in average occupancy rates. As expected, with “full occupancy” across most facilities, rent growth will continue to be the primary driver of same-store performance in 2022. Storage REITs had initially expected rent growth on new leases to be flat-to-negative in 2022 and had expected to lean heavily on rent increases on existing leases to drive NOI growth, but new lease rates have trended ahead of initial expectations throughout the year thus far.

Self-Storage REIT Performance

Despite this strong fundamental performance, storage REITs trade near their lowest relative valuations in a decade compared to the REIT Index with a sub-20x P/FFO and trade at notable discounts to private market valuations as well. The Hoya Capital Self-Storage REIT Index – a passive market-cap-weighted index – is now lower by 24.9% for 2022 – above the 33.1% decline from the Vanguard Real Estate ETF (VNQ) but lagging the 22.8% decline from the S&P 500 ETF (SPY). The decline this year follows robust total returns of nearly 80% in 2021, as storage REITs were the second-best-performing property sector last year which was a much-needed reversal of fortunes after storage REITs lagged the REIT Index in three of the prior four years.

The selling pressure this year – and over the past quarter in particular – has been seemingly uncorrelated with fundamentals with National Storage dragging on the downside despite posting some of the strongest upside earnings surprises relative to expectations, while micro-cap Global Self Storage has interestingly escaped the selling pressure. Public Storage has been the leader among the five major storage REITs this year while the three mid-cap REITs have delivered similar year-to-date declines of around 30%.

Storage REIT External Growth Prospects

Importantly, on their earnings calls, all five major storage REITs discussed their expectation for moderating supply growth in 2022 and into 2023 as the lagged effects of the weak pre-pandemic fundamentals along with elongated construction timelines continue to suppress speculative development, which should help to alleviate the oversupply issues that weighed on fundamentals in the late 2010s. Consistent with this commentary in earnings calls, construction spending data from the Census Bureau has indicated that the peak in development appears to have occurred in 2017 and declined by more than 10% in 2021, but soaring rents and record-high occupancy rates have spurred a rebound in starts over the past several quarters.

Acquisition and consolidation opportunities should remain plentiful over the next decade for these storage REITs following the late-2010s supply boom, and we did indeed see acquisition activity ramp up over the past several quarters as these REITs acquired more than $10B in assets over the past year. Fueling this record pace was a pair of acquisitions from Public Storage: a $1.8B acquisition of ezStorage – a 48-property portfolio in the Washington DC region, and a $1.5B acquisition of All Storage, which owns 56 properties in the Dallas market. Additionally, earlier this year, CubeSmart completed a $1.7B acquisition of Storage West – an owner and operator of 59 self-storage assets in Southern California, Phoenix, Las Vegas, and Houston.

Importantly for their external growth prospects, self-storage REITs operate with some of the most well-capitalized balance sheets across the real estate sector. On average, self-storage REITs operate with debt ratios that are well below the REIT sector average of 25%, led by Public Storage, which operates with perhaps the most conservative balance sheet within the REIT sector with one of the few, coveted “A-rated” long-term bonds. CubeSmart, Life Storage, and Extra Space all hold investment-grade long-term bond ratings as well. All six self-storage REITs operate with debt ratios below 30%.

Deeper Dive: Self-Storage Fundamentals

There are roughly 50,000 self-storage facilities in the United States, and proximity to one’s home (generally 3-5 miles) is typically cited as the most important feature. One in ten US households rent a self-storage unit, and 70% of self-storage customers are residential, with the other 30% split between businesses, students, and the military. The self-storage industry remains a highly fragmented industry, and these six REITs own roughly 20% of the total square footage in the US. Storage demand exhibits high correlations with moving rates, and recent reports from Amerco (UHAL) and Zillow (Z) indicated a “Great Reshuffling” with sustained levels of higher moving rates into lower-cost Sunbelt and secondary markets driven, in large part, by the flexibility to work-from-home.

Self-storage REITs comprise roughly 5-8% of the broad-based “Core” REIT ETFs and also comprise roughly 3-4% of the Hoya Capital Housing Index, which tracks the performance of the US housing industry. The three largest REITs – Public Storage, CubeSmart, and Extra Space – operate relatively higher-rent portfolios in more primary markets, while Life Storage, National Storage, and Global Self Storage operate facilities with lower rents in secondary and tertiary markets. Revenue and expense management technology, brand value, and cost of capital have historically given these REITs a competitive advantage over private market competitors and smaller brands.

Rent collection has remained essentially spotless throughout the pandemic, consistent with our predictions early in the pandemic in which we projected that collection rates should remain resilient because rents are essentially “collateralized” by a renter’s stored possessions as unpaid rents result in the repossession and auction of the goods within the storage locker. Additionally, the operating efficiency of the self-storage business is second to none in the real estate sector, commanding some of the highest NOI margins in the real estate space at over 70% while requiring minimal ongoing capital expenditures to maintain the facilities. A double-edged sword for these REITs, the ease and efficiency at which operators can enter the market has resulted in a wave of speculative supply growth coming online over the last half-decade.

Self-Storage REIT Dividend Yield

Storage REITs were one of the only property sectors that went completely unscathed by the wave of coronavirus-related dividend cuts that swept across the REIT universe in 2020 and were among the leaders in dividend growth in 2021 and 2022 as well. Storage REITs pay an average dividend yield of 3.4% which is slightly below the market-cap-weighted REIT sector average of 4.1%. Self-storage REITs pay roughly 60% of their available cash flow, leaving plenty of cash flow to fuel accretive growth through acquisitions and development.

Diving deeper into the sector, we note that the dividend yield ranges from a high of 5.48% from National Storage to a low of 2.80% from Public Storage. Notably, CubeSmart, National Storage, and Extra Space have been among the leaders in dividend growth across the REIT sector over the past five years with 7-11% average annual dividend growth rates.

Takeaway: Locked-In And Sticky Demand

Self-Storage REITs have defied expectations to the upside as comprehensively as any real estate sector since the start of the pandemic, delivering FFO growth of over 50% since 2019 and NOI growth of roughly 30%. Incremental storage demand is driven by change – particularly home moving rates and household formations. Surging mortgage rates have had a “lock-in” effect among existing homeowners while also pricing-out new formations. While the rate-driven slowdown in housing market activity is expected to temper incremental storage demand, recent data and interim REIT updates have indicated “sticky” demand trends continued deep into the third quarter. Given the deeply discounted valuations, we like the risk/reward at these levels, particularly given the ‘stickiness’ of demand, strong balance sheets, low cap-ex needs, and impressive operational track record.

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