Description

We follow a “supply-side” shorting philosophy.  Our approach is to seek out companies and industries that face a coming wave of new supply – overproduction of a commodity, overbuilding of an asset class, the entrance of one or more new competitors, etc. – that may disrupt pricing and lead to substantially lower future business profits.

One of our favorite short themes today is self-storage.  Construction of self-storage facilities currently is well above “normal” on a through-the-cycle basis and beyond the market’s ability to absorb the capacity additions.  At the same time, self-storage valuations do not reflect the threat to revenues, margins, and profits, with cap rates of publicly-traded self-storage firms hovering near 5%.

Self-storage stock prices recently had a modest bounce in the wake of the 2017 hurricane season.  We view current price levels as an attractive entry point for self-storage names on the short side.

Short Thesis

We currently hold short positions in a basket of self-storage companies, including (but not necessarily limited to) Public Storage (“PSA”), Extra Space Storage (“EXR”), and CubeSmart (“CUBE”).  For purposes of this write-up, we highlight CUBE, a $4.7B Pennsylvania-based self-storage company trading at 18x FFO.  We believe CUBE has the greatest exposure to markets experiencing the most significant growth in both traditional and non-traditional supply.  We also quote PSA’s internal metrics in this article as PSA is the largest self-storage company in the US and is a reasonable proxy for broader industry trends.

The combination of this new supply along with potentially softening demand for self-storage services may result in higher vacancy rates and negative pricing, driving the profitability of self-storage companies below market expectations.  We see 30-50% downside to CUBE’s fair value.

The Rise and Rise of Self-Storage: A Brief History

Over the last eight years, self-storage companies have enjoyed a “golden age” as a benign supply environment has led to a powerful twin tailwind of higher occupancies and rising rental rates.

As shown in Exhibit A, from 2000 to 2009 the average annual value of US self-storage construction put-in-place was $1.1B.  From 2010 to 2015, the average annual value of self-storage construction put-in-place plunged to $0.5B, a six-year average that was less than half what it had been the prior decade.

               Exhibit A

Sources: SunTrust Robinson Humphrey, US Census Bureau, CBRE

The impact can be clearly seen in PSA’s financial statements.  From 2010 to 2016, PSA’s occupancy rose by 470bps and realized rental rates increased at a CAGR of +4.8%.  Today, industry-wide occupancy rates are above 90% - the highest level in the last 30 years (see Exhibit B).

               Exhibit B

Sources: SunTrust Robinson Humphrey, Public Company Filings, Self-Storage Almanac 2016

It’s of little surprise that the self-storage stocks have been home run investments over this time period.

An Onslaught of New Traditional Supply…

When it comes to supply of self-storage units, we think the next five years will look quite different from the last five.

Starting in 2016, construction of new self-storage facilities has soared to record heights (see Exhibit A).  The annual value of self-storage construction put-in-place in 2016 was $1.9B – not only the highest figure since the year 2000 (in 17 years), but a figure that blew away the next-highest year by roughly 50%.  2017 is on-pace to go even higher, with $1.3B already put-in-place through May.

Analysis from Cushman & Wakefield tells the story.  In Q2 2017, the total number of self-storage new construction starts including alterations, renovations, and interior construction reached 114 for the quarter – up from 49 in Q2 2016 and 47 in Q2 2015.  The surge in total new construction to-date in 2017 has been staggering (see Exhibit C).

               Exhibit C

Source: Cushman & Wakefield

Anecdotal comments from the self-storage companies corroborates the industry data.  On PSA’s Q1 2017 earnings call, CEO Ron Havner noted that “at least 2,250 properties” would enter the market in 2017 and 2018.  To put this in context, in a November 2014 investor presentation EXR stated “[the] market can absorb 540 new properties annually without outpacing demand.”  The figure cited by PSA’s CEO indicates capacity expansion will be more than double what the market can absorb for the foreseeable future.

…With Non-Traditional Supply the Exclamation Point

In addition to traditional self-storage facilities, the current cycle has seen the emergence of new non-traditional “shadow” supply that may affect self-storage in a manner similar to AirBnB’s effect on the hotel REITs.  Specifically, a number of VC-backed start-ups are exploring different models to disrupt the self-storage industry.

The four leading VC-backed start-ups are Clutter, MakeSpace, Omni, and Trove.  The value proposition is simple: each company will come to your home or apartment, pack your items, bring them to a 24/7 guarded facility, and store them.  Customers can then schedule a delivery of any item on-demand.  The start-ups rent facilities in the lowest-cost areas of town and pass on the savings to customers – for example, a 5x10 storage facility in Los Angeles with MakeSpace costs $145/mo vs. a roughly equivalent 5x10 facility with PSA at $162/mo.  Even using aggressive assumptions for packing and hauling costs, MakeSpace still frequently comes out not only as a more convenient option, but also as a cheaper option than PSA.

VC firms have been keen to provide funding.  Clutter recently raised $64M in Series C funding from VC juggernauts Sequoia and Google Ventures.  Clutter’s founder claims the company is profitable on 100% of customers.  We have spoken with VC firms who lost out on the Clutter deal to Sequioa.  They have extraordinarily high praise for Clutter even after not participating in the deal.

Most ominously, these VC-backed start-ups are targeting the incumbent self-storage companies’ best territories first.  New York, Chicago, Los Angeles, and San Francisco are all in the cross-hairs.  We think it’s just a matter of time before the relatively unsophisticated self-storage industry is disrupted by the new competition with a better, more convenient, more cost-effective mousetrap…and the extraordinarily deep pockets required to expand rapidly.

Demand Trends Are Worrying Too

In addition to the ominous supply trends, we are also concerned by demand.  Much has been made of Millennials favoring “experiences” over “things,” potentially reducing the need for self-storage facilities in the future, but only recently has this begun to show up in the numbers.

According to industry data from Cushman & Wakefield, the ratio of move-ins to move-outs in self-storage facilities flipped from positive to negative in mid-2016.  The ratio is now solidly negative for the first time since the 2008-09 financial crisis.  Of particular concern, this ratio has uniformly gone negative across geographies – in other words, it has nothing to do with whether a market is seeing a large supply increase or not.  For those markets that are seeing substantial capacity additions, we view this as a deeply worrying trend.

The Self-Storage Stocks

Our preference is to be short a basket of self-storage names, as many of the publicly-traded companies are valued at 18-20x FFO.  However, for the purposes of VIC our choice is CUBE.

               Exhibit D

Sources: SunTrust Robinson Humphrey, SNL, Public Company Filings

As can be seen in Exhibit D, CUBE has the highest exposure to MSA’s experiencing the most supply growth in the US.  In addition, CUBE has strong concentrations in MSA’s such as New York and Chicago where the VC-backed start-ups may have the most impact.

From a stock perspective, sell-side analysts almost uniformly forecast occupancy levels to maintain at the current high levels with continued low-mid-single-digit growth in realized rent per square foot.  Our variant view is that neither will prove true.  In coming years, we think occupancy levels may decline, realized rental rates may decline, operating margins may shrink, and valuation multiples may contract.  Ultimately, instead of trading at 18-20x FFO on current cash flows, we think the entire group could trade at 13-15x FFO on materially lower cash flows.  This would lead to anywhere from 30-50% downside from current levels.

Our focus on the short side is on companies and industries where a lot of new supply is on the horizon, but share prices are not yet priced for the threat.  We believe this is a fair description of the self-storage industry today.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds short positions in the securities mentioned, which can be considered long-term holdings. Author may sell short additional shares, or buy to cover some or all of Author's shares, at any time. Author has no obligation to inform anyone of any changes to Author's view of PSA, EXR, or CUBE. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While Author has tried to present facts it believes are accurate, Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in PSA, EXR, or CUBE. READER AGREES TO HOLD HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.

Catalyst

• New supply causes occupancy levels to fall
• New supply causes realized rental rates to fall
• Self-storage margins and profits disappoint relative to consensus expectations