Public Storage: Remains Attractive With A 4% Dividend Yield (NYSE:PSA)

Investment Thesis

Following a challenging year of underperformance for REITs, the recent shift in discourse at the Federal Reserve has infused optimism into the market, triggering a rally in certain stocks within the sector.

Among the diverse real estate companies, one specific segment consistently stands out for its greater resilience to macroeconomic events and sustained demand – the self-storage sector. Public Storage (NYSE:NYSE:PSA), a leader in this sector with the largest scale, takes center stage in this article. We will explore the qualities that contribute to the sector’s resilience, examine key ratios, and project potential returns based on the current share price.

Business Overview

Public Storage is a self-storage company that operates in the United States. It is one of the largest self-storage companies in the world. The company provides storage solutions for individuals and businesses, offering a variety of unit sizes and types to meet different storage needs.

Public Storage typically operates by renting storage units on a month-to-month basis, allowing customers to store their belongings in a secure and accessible facility. The company owns and manages numerous storage facilities across various locations, providing a range of services such as climate-controlled storage, vehicle storage, and packing supplies.

Resilience to Macroeconomic Crises

Self-storage services tend to be quite resilient to macroeconomic crises because the demand for self-storage is often driven by life events such as moving, downsizing, marriage, divorce, or a death in the family. These events tend to persist regardless of economic conditions, creating a consistent level of demand. Additionally, by offering month-to-month rental agreements, customers have greater flexibility, and the hiring process has less friction compared to reserving a space for a fixed term, such as a year, for example.

This resilience is evident in the performance of revenue and EBITDA margins of companies like Public Storage or Extra Space Storage during the great crisis of 2008. Between 2007 and 2009, revenue decreased by a total of 9%, while margins remained fairly stable. In other words, a Real Estate Investment Trust only experienced an annual revenue decrease of 4.5% during the two years of the biggest real estate crisis in recent history.

Growing and Fragmented Market

The self-storage market in the United States has experienced growth in recent years, and the expectation is that the global market will continue to grow at mid-single digits until at least 2029. This growth is attributed to the steadily increasing population in the United States, as more people often lead to an increased demand for storage solutions. Urbanization and demographic trends, including millennials moving to cities for work opportunities, contribute to the need for additional storage space. Companies like Public Storage, being leaders in the sector, typically meet this demand by providing flexible contracts for storage spaces.

Furthermore, the culture of consumerism and the tendency to accumulate possessions also contribute to the demand for storage space. As people acquire more belongings, they may require extra space to store items that no longer fit in their homes. Considering that apartment rentals are becoming increasingly more expensive, this could compel users to rent smaller places, subsequently necessitating additional spaces to store objects they can no longer accommodate in their new homes.

This sector is characterized by fragmentation, with numerous small and independent operators alongside a few larger national players. The relatively low barriers to entry in the self-storage industry make it easier for entrepreneurs and local investors to start and operate their facilities. Compared to some other real estate sectors, developing and managing a self-storage facility may require less initial capital and expertise.

The four main players in the sector are Public Storage, generating $4.48 billion in the last twelve months, Extra Space Storage with $2.32 billion, CubeSmart with $1 billion, and National Storage with $860 million in revenue. Recently, U-Haul, initially a moving items transportation company, entered the lucrative self-storage segment, leveraging its large distribution network and brand power.

Despite the significant revenues of these five competitors, they only account for 30 to 40% of the total square footage available for self-storage rental. The remaining 60 to 70% of the market share is distributed among hundreds of small competitors, making them M&A targets for larger players and contributing to substantial inorganic growth. Public Storage, for instance, notes that since 2019, 18% of its growth has come through acquisitions, including the recent $2 billion acquisition of Simply Self Storage in 2023.

Key Ratios & Competitors

The company has achieved an annual revenue growth of 8.6% over the last decade while maintaining an average Funds From Operations margin of 65%. In REITs, FFO is a crucial metric as it measures operating performance and cash generation, excluding one-time cash inflows like income from asset sales.

However, an area for potential improvement is the dividend per share, which has only grown by 5% in the last decade. Between 2017 and 2022, the annual dividend remained constant, likely due to representing 80% of the FFO. The company, with an average FFO Payout Ratio of 70% over the last ten years (currently at 68%), may have room to increase dividend payments.

Despite a total debt increase to $9 billion, the Debt/Equity ratio stands at 88%, considered favorable for a REIT. Any ratio below 200% is generally considered good.

To provide context, comparing these figures with the company’s four main competitors is insightful. Public Storage stands out with the highest revenue and FFO margins, showcasing a correlation between scale and margins because the companies can benefit from economies of scales, spreading fixed costs, such as property management, administrative expenses, and marketing, across a larger portfolio of properties. This can result in lower average costs per unit, contributing to improved FFO margins.

On the other hand, it is also the one that has grown its FFO the least in the last five years, which can be understood because it is also the largest company. And despite its leadership and scale, its P/FFO Ratio is on average 18x, although it is also the one that offers the lowest dividend yield, but we already saw that this could change soon because the FFO Payout Ratio is quite low.

Valuation

To project the potential performance of an investment in the company at its current price, let’s consider the growth of Funds From Operations (FFO) and apply an exit multiple. The management’s guidance for this year is a modest 2% FFO growth, translating to an FFO per Share of approximately $16.70.

Shifting toward the outlook, we sit here in October, raising our core FFO range once again, increasing both the low and high-ends to $16.60 at the low end to $16.85 at the high end.

Q3 2023 Conference Call

This conservative growth is influenced by factors such as decreased mobility due to rising interest rates and recession fears, causing delays in moving projects. For subsequent years, a return to the 8-9% average growth of the last decade is anticipated.

Move-in rental rates continue to be lower for us and the industry, but we are seeing strong move-in volume along with the right mix of marketing spend and promotions. Our existing customer base continues to perform well with move-out volumes further moderating this quarter.

Q3 2023 Conference Call

Applying a P/FFO multiple of 20x, assuming a more positive environment for REITs, could yield an 8.5% return on the share price. Coupled with a 3.5% annual dividend, the total return could reach 12%. While not overly attractive, it’s noteworthy given the defensive nature of the business.

If the share price returns to around $260 USD, the expected return could be an enticing 15%.

Risks

While we’ve acknowledged the resilience of self-storage companies, it’s crucial to recognize that they are not entirely immune to economic challenges. In severe and prolonged economic downturns, cost-cutting becomes a priority for individuals, and businesses may scale back operations, potentially impacting the demand for storage services.

Moreover, oversupply in specific markets can affect occupancy rates and rental prices. Therefore, although self-storage is generally considered resilient, its performance can still be influenced by broader economic conditions. Given the high competition and minimal differentiation among these services, a crisis could easily trigger a price war as companies vie to attract consumers with more affordable options.

Final Thoughts

It appears that companies in the self-storage sector possess desirable investment characteristics. The market’s fragmentation provides opportunities for companies to emerge as leaders, and with sector growth and a certain resilience in demand, these firms demonstrate promising attributes. Public Storage, in particular, stands out due to its achieved scale in the sector.

However, it’s worth noting that recent rallies in REITs have led to less attractive valuations compared to a few months ago. This is particularly evident in the case of PSA, which experienced a rapid increase from $240 to $300 in just two months. Nevertheless, given the quality of the business and a 4% dividend yield, a ‘buy‘ rating doesn’t seem entirely unreasonable. In the event of a healthy market correction, increasing the position could be a logical move.