The self-storage REITs have returned 30% in 2019, riding a wave of multiple expansion driven by a flight to safety within REITs and the broader market. While self-storage is a great business and the self-storage REITs are well run companies, as with any investment valuations sometimes get detached from reality. With fundamentals that continue to be un-inspiring, we are skeptical that the self-storage REITs will be able just justify their lofty valuations over the next 12 months. The chart below shows the price/AFFO (cash flow) multiple for Extra Space Storage (EXR), along with same store revenue growth going back to 2012. As you would imagine, higher multiples tend to be correlated with higher organic growth. That is, until 2019. This year has seen EXR trade to near all-time highs relative to forward cash flow estimates, despite same store “SS” revenue growth that is near the lowest it has been in 7 years. The second chart corroborates this story, showing EXR trading at a 40% premium to it’s consensus NAV. This is a valuation premium that the company has only reached once in the past, when SS revenue growth was closer to 8% and the company’s NAV was growing at 30-40%. It’s currently growing at 3%.

What is the market telling us by driving EXR to these lofty valuation levels? Either fundamentals are set to accelerate meaningfully, or the market is willing to pay a huge premium for a property type they see as “counter-cyclical.” The first thesis we can basically throw out the window. Below are a sampling of comments from Q2 2019 self-storage REIT earnings calls.

EXR – discussing same store revenue – “So without getting into too much detail in the exact cadence here, we obviously decelerated from quarter one to quarter two by about 30 basis points. We are assuming that, that cadence — or some sort of that cadence continues into the back half of the year where we continue to decelerate and depending on where you are in the high and the low, I mean, it’s pretty simple math in order to get there. But without giving guidance as to where we are in that range, I think we do assume deceleration.”

CUBE – discussing the impact of supply on fundamentals “Can we infer from that, that you kind of and? Perhaps the industry– or likely kind of put the bottom in on fundamental this year or you do you think there’s a drag of that into next year as well?” Christopher P Marr, CEO “Yeah, I think if in terms of same-store metrics using that specifically as fundamentals, it will drag into next year.”

PSA – discussing supply “And like I said, we’re sensing that there is likely to be in that 10% to 15% stage or shift down going from this year to next year, but that still puts you north of $4 billion of deliveries. That’s a lot of product. So, we’re keeping a very close eye, we’re not confused about how it impacts certain markets, as I mentioned earlier and the good news is, we feel more and more encouraged that we’ve got the playbook to continue to navigate around it”

EXR telegraphing decelerating revenue growth into the end of the year. CUBE discussing continued revenue pressure due to new supply. PSA mentioning that supply may be topping, but is still elevated. Not a set of comments that would indicate fundamentals are set to accelerate meaningfully this year or next.

This leaves us with the explanation that the market is currently placing a LARGE premium on the self-storage REITs because they are viewed as “safe”. This makes a certain amount of sense, as Public Storage (PSA), famously has one of the best balance sheets in the REIT industry. In the instance that investors desire balance sheet safety, PSA is a large-cap liquid way for investors to get this “safe” exposure.

But where do we go from here? If we look forward 6 months, what will be the rationale for owning the self-storage companies? Let’s play out two different scenarios.

In the first scenario, the fed lowers rates rapidly, the Trump administration gets a trade deal with China done, and economic growth re-accelerates. This would likely trigger a flight to risk, rendering the safety trade unnecessary. The 10y yield rises, investors sell REITs, and REIT investors want to own the lodging REITs, which currently trade at 20% discounts to NAV, versus the storage companies at 20% premiums.

In the second scenario, economic growth continues to decelerate, investors continue to look for safety, but as the employment data worsens, demand for self-storage assets starts to fall. In this scenario, same store revenue growth falters in 2020 as new supply continues to be delivered at a rapid pace. Suddenly the huge valuation premiums are given back as investors realize that the storage industry has a cyclical component.

Heads the storage REITs lose, tails the storage REITs lose. If economic growth gets better or worse, in our view it is increasingly probable that the self-storage REITs will NOT be able to maintain all-time high valuation levels. Either fundamentals will begin to deteriorate, or the safety trade will eventually reverse in favor of riskier asset classes. Even if the safety trade remains in vogue, and economic growth does not get worse, and fundamentals somehow improve…how much upside is available when trading at such large premiums?

We are not negative on the self-storage industry long-term, but over the next twelve months we have no choice but to be bearish as valuations move higher with little underlying improvement in fundamentals. The probability that these companies trade at such elevated levels for a long period of time is low without an improved outlook. For now we are storing our capital elsewhere. Pun intended.

Martin Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Cell: (630) 730-5745

**All charts generated using data from Bloomberg, LP, S&P Global, and Serenity Alternative Investments

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