Is the Box Half-Full or Half-Empty?

Is the Box Half-Full or Half-Empty?

Self-storage REITs rocked in 2011. Can the rally last?

Anyone familiar with A&E's reality show “Storage Wars,” which follows a group of speculators who buy the contents of abandoned self-storage lockers, break them open and rummage through the junk looking for value, knows these types of properties can sometimes yield riches.

But you didn't need a pair of metal clippers to score big on self-storage in 2011. Publically traded self-storage real estate investment trusts posted the biggest gains of all REIT sectors in 2011 with a 34.98 percent return and a 2.89 percent yield; next up was manufactured homes with a total return of 20.3 percent and 3.45 percent dividend yield, according to data compiled by SNL Financial. The broader REIT universe posted a mere 8.33 percent return and a 3.74 percent yield.

That extended a long rally in the self-storage REITs over both three- and five-year periods. (See chart, page 64.) Four REITs — Public Storage (NYSE: PSA), Extra Space Storage Inc. (NYSE:EXR), Sovran Self Storage Inc. (NYSE: SSS) and CubeSmart (formerly known as U-Store-It) (NYSE: CUBE) — posted total returns of double or triple digits for the three-year period, according to data from SNL Financial.

Can the boom continue? Consider that as of Jan. 9, the self-storage REIT sector was trading at a 29.9 percent premium to net asset value (NAV), according SNL Financial. That's the second richest valuation of all REIT sectors; healthcare REITs top the list at a 30.9 percent premium to NAV. Multifamily REITs were trading at a 1.9 percent discount to NAV.

Michael J. Salinsky, director of REIT equity research for RBC Capital Markets, is bearish. He says that investor interest outpaced the improvement in the sectors' fundamentals. “Although we saw very healthy growth in the second half of the year with [net operating income] up 5 to 6 percent for the year, that's not enough to drive a 35 percent increase in stock prices,” he says. His firm has underweighted the self-storage REIT sector. “Valuations already reflect a good 2012 — they appear quite full.”

Bank of America Merrill Lynch disagrees. “Weighing the risk, and based on valuations on 12-month forward NAV, we think it's very attractive,” says analyst Jana Galan, who foresees consolidation in the industry. The firm has “overweighted” the sector going into 2012.

A Sector that Thrives on Change

To understand the rally, and get some perspective on where it's going, it's helpful to look at some of the underlying drivers.

The self-storage industry has been one of the fastest-growing sectors of the U.S. commercial real estate industry for more than 35 years, with more than 46,500 self-storage facilities operating in the U.S. today, according to the Self Storage Association. About 70 percent of the demand for self-storage comes from residential users, the rest usually from small businesses like landscaping or construction. Almost any life event that forces a change or transition, whether good or bad, can create demand for storage — new job or job loss, divorce or marriage, children leaving home for college.

Given that intimate connection to lives in transition, self-storage demand closely tracks the performance in multifamily real estate, says Salinsky. That's given H. Michael Schwartz, chairman and CEO of Strategic Storage Trust, the confidence to recently invest $80 million to buy 12 self-storage properties. “If you can buy at a cap rate 150 basis points greater than multifamily properties, you can carve off better yield,” he explains. That yield translates into better total returns for investors.

Over the past 12 years, the number of households using self-storage has increased about 65 percent, according to the Self Storage Association. Today, nearly 1 in 10 U.S. households, or 10.8 million households, currently rent a self-storage unit, an increase from 1 in 17 U.S. households in 1995.

In addition to growing demand, the average length of stay for self-storage tenants is currently averaging 12 months, up from 11 month just two years earlier, according to Salinksy. All of these factors point to “healthy growth again in 2012.”

RBC Capital Markets has forecast average renewal rent increases of 6.5-8.5 percent for tenants staying more than nine months. The firm also expects strong occupancy gains from 2011 to allow operators to decrease concessions/incentives, which would raise street rates on new leases by 2.5-3.5 percent in 2012. Rates rose 1.2 percent in 2011. Additionally, the sector has seen very little new supply, which helps operators maintain occupancy and push rental rates.

Rolling up the Mom and Pops

Galan predicts acquisitions will drive value this year. There is plenty of room; most of the industry is fragmented across small regional operators. The four publicly-traded self-storage REITs control only 7.5 percent of the facilities in the nation. But bigger marketing budgets and economies of scale should allow them to roll up the smaller players. “Smaller operators are losing customers to REITs and are realizing they can't compete,” Galan notes.

In 2011, for example, CubeSmart (CUBE; f/k/a U-Store-It) invested $560 million for 22 self-storage facilities in New York City, a 30 percent expansion for the once struggling REIT. “This is a dramatic shift in the industry - a consolidation that we've been expecting for a long time,” Galan says. “It started in 2011 and we think it will continue, offering opportunities for REITs.”

Galan also points out that fundamentals haven't returned to the peak levels seen in 2006 and 2007. “Although we've dramatically improved, we have not seen commercial users come back,” she notes. “That is something that will have a positive impact on REITs in 2012.”

Salinsky agrees fundamentals will improve in 2012 but not enough to merit additional upside in the price of the REITs. “The relative upside in storage stocks is more limited compared to other REIT sectors,” he asserts.

The traders on “Storage Wars” have only limited visibility into the assets they are looking to acquire — before they bid they are given a few moments to stand outside the opened locker and look in, but cannot enter or rummage through the junk. They make decisions out of instinct and intuition, and with a fair tolerance for risk. Investing in the self-storage REITs in 2012 will require the same.

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