Thinking Inside the Box: The Self-Storage Industry
When most people think about commercial real estate, they likely picture gleaming office towers, luxurious shopping malls, or state-of-the-art apartment complexes. While those properties are a large part of the real estate landscape, a far less glamorous property type has generated top-tier returns over long periods of time: self-storage facilities. These assets are perhaps best known in popular culture for their grimy-looking appearances on crime-scene TV shows, but the business has several distinguishing features and competitive advantages that should make it favorable for long-term investors. Four of the industry’s five largest players are public real estate investment trusts (REITs), and we believe that some of these companies fit well into our long term-focused strategies.
What makes self-storage such an attractive asset? For starters, it’s certainly not a glamorous type of building to own. Plenty of people would be happy to point to the new skyscraper as their development but far fewer would brag about owning a single storage facility. Large institutional investors also find it difficult to put large amounts of capital to work by buying or building storage facilities as individual stores are fairly inexpensive relative to other property types, which has reduced competition while allowing existing companies to opportunistically buy properties. Development has been restrained relative to other property sectors over long periods of time as many municipalities prefer other types of real estate to self-storage because storage employs relatively few people and is also seen as less aesthetically appealing than things like shopping centers or apartment buildings. This kept valuations reasonable for a long time, with capitalization rates above other property types. In recent years new development has increased, which has slowed rent and occupancy growth, but construction should be constrained over the long term because of rising land costs, which favor higher and better use projects, as well as zoning restrictions (New York City is the most recent and notable example).
Industry demand comes from a variety of factors that are not predictably correlated with economic cycles. Storage facilities are a place to keep extra stuff during life events, which the industry refers to as the “Four Ds”: death, divorce, dislocation, and downsizing. These events underscore the fact that storage demand is often related to disruptive things, and is fairly transitory. The industry certainly doesn’t try to profit off of misfortune and has been careful around large-scale disasters such as hurricanes to keep or increase their discounts and not raise rents on existing tenants. Still, events where people are moving around and need a place to store their stuff are the primary demand drivers. A storage industry trade group estimates that about 8% of the U.S. population uses a storage facility, despite storable goods falling as a percentage of overall personal consumption. Sadly, these life events occur with regularity and likely will continue to do so. However, these drivers also mean that storage demand is fairly inelastic: customers won’t put their things in a facility simply because the price goes down.
Recently a fifth “D” has become relevant: density. Many items today have become digitized or obsolete as technology has improved. A decade ago, many people would likely have a CD and DVD player as well as numerous CDs and DVDs, in addition to an address book, a calendar, a camera, and physical photographs. Today, all of those things and more can fit on a single smartphone or in the cloud. In addition, many in today’s younger generation prefer spending money on experiences instead of things, which has reduced demand for storable goods. The offset to these trends has been the move towards urbanization. With many workers and even retirees flocking to the cities and prioritizing so-called live/work/play areas, high-rise apartment demand has been strong. As these are in major metropolitan areas where land is scarce and expensive, the units tend to be smaller than suburban units and houses. Some residents may also choose to take smaller units – say, a studio instead of a one-bedroom – and supplement with a storage facility as an extra closet. With density continuing to increase in major cities and apartment size shrinking, this should continue to be a tailwind for demand and help offset some of the weakness in storable goods. Technology advances do pose some long-term risks to the sector, however, in the form of further storable goods slowing, valet storage providers, disintermediation from online search companies or data aggregators like Google or Sparefoot, and even driverless cars, the latter of which could free up significant garage space for storage customers that own homes.
Self-storage has a unique advantage among property companies: economies of scale. Very few property types lend themselves to economies of scale because most property is local, hence the famous “3 Ls” of real estate. A corporate tenant leasing office space in one city cares deeply about the particular location as well as the price per square foot; the landlord doesn’t factor highly in the decision of where to lease. In addition, the landlord would have to market each floor locally, probably through a broker, so owners couldn’t market space in multiple cities to an individual tenant. Finally, most properties don’t benefit much from a brand name. In contrast, while most storage customers come from within a three-mile radius of the store, the large self-storage companies have well-known national brands. Additionally, with most customer searches for storage starting online, having platforms with significant online advertising ensures that these companies will be top of mind for searches in any city. The large players also have national call centers and can advertise across multiple media platforms, giving them scalable marketing across the country. In fact, the four largest storage REITs – Public Storage, Extra Space Storage, CubeSmart, and Life Storage – all manage and brand assets on behalf of smaller third-party owners who realize that it would be tough to compete with the brand and scale of the largest players. These third-party management platforms, in turn, provide the companies with better data and systems than their owned portfolios might support on their own, which gives them better data to set pricing and see trends by stores, cities, and regions.
Another advantage for storage owners is the relatively low cost of operations and minimal maintenance capital expenditures. Storage facilities don’t need a lot of bells and whistles or amenities – just basic floors, lockers, and security – and the costs to turn a locker when a customer leaves is minimal. Vacant lockers cost little to maintain as they require no energy or power, and because customers are responsible for moving their items, a large facility can be fully staffed with very few employees. Pricing for storage lockers varies by unit size but is generally set by a headquarters pricing team with daily and national data, while smaller players have less sophisticated pricing tools. This allows individual facilities to break even at fairly low occupancy levels (35-40%), and thus the companies operate with strong net operating income (NOI) margins (high-60% to low-70% range) as occupancy gets above 90%.
These low costs provide an additional benefit in the form of minimal required maintenance capital expenditures as a percentage of NOI. Capex is an oft-overlooked long-term cost of owning real estate, and it can be ignored for long periods of time or pushed off within spreadsheets to make returns look more favorable, but property investors know that the bill always comes due. Glitzy property types like offices and hotels need constant and costly updates, which can cause very large discrepancies between reported earnings and actual cash flow. Among property sectors, storage has the lowest capex cost at roughly 5% of NOI. This is less than half the average cost for commercial real estate and far less than that of office buildings and full-service hotels. Over time, these lower costs give property owners more free cash flow for growth, an important consideration when evaluating a REIT.
CAPITAL EXPENDITURE AS A PERCENTAGE OF
CASH NET OPERATING INCOME BY PROPERTY SECTOR
Source: Evercore ISI Research. © Copyright 2018, Evercore Group L.L.C. All rights reserved.
Finally, the storage industry is fairly fragmented, offering growth opportunities for the larger public players. The top five owners, which include the aforementioned public REITs and the parent company of U-Haul, control only about 20% of the industry square footage; Public Storage, the largest owner, controls roughly 7%. A fair amount of the non-public square footage is comprised of strong regional players and other institutional-quality assets, some of which are already managed by the REITs, and this should provide ample growth opportunities in the coming years thanks to the operational advantage of the REITs.
REITs are required to distribute 90% of their taxable income in the form of a dividend, in return for which they are exempt from corporate taxation. This makes them attractive dividend-paying stocks but also severely limits their ability to retain cash flow and makes them more susceptible to the capital markets. As such, we believe a focus on balance sheet is very important when evaluating REITs. Diamond Hill’s investment in the sector is comprised of Public Storage and CubeSmart, which have the lowest debt-to-EBITDA ratios among storage owners and some of the better balance sheets within the REIT industry; Public Storage has had the lowest debt levels among REITs for many years now. We believe the combination of strong national brands, operational advantages, low costs, and sturdy balance sheets should position these companies well for the coming years.
As of May 31, 2018, Diamond Hill owned shares of CubeSmart and Public Storage.
Originally published on June 20, 2018.
The views expressed are those of the research analyst as of June 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.