Date: 2024-05-15 Page is: DBtxt003.php txt00016921
Company / Investment
Public Storage
Seeking Alpha: Public Storage: A Recession-Proof SWAN You Can Trust
Peter Burgess
Summary
I expect Public Storage to generate safe and recession-resistant dividends as well as approximately 7.5% total returns over the coming five to 10 years.
Right now Public Storage is trading at 22.2 times FFO, right at its five-year average, though slightly higher than its 20 year average of 18.9.
Just don’t forget that no REIT is a bond alternative.
This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »
Co-Produced with Dividend Sensei
Benjamin Graham, one of the best eight investors in history (and the father of value investing, which seven of those eight have used to generate their incredible returns) famously said,
“In the short run, the market is like a voting machine -tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine - assessing the substance of a company.”What Graham meant is that in the short term the market is dominated by sentiment, often irrationally pricing stocks based on one popular theme or another. But over the long term (ie 5+ years), fundamentals such as cash flow and dividends wash out sentiment and ensure that quality companies always appreciate in value.
This has certainly been the case with Public Storage (PSA), America’s largest storage REIT. While it, like all stocks, has been volatile and underperformed at times, there's no denying the incredible income and wealth compounding abilities of this level 10/11 quality SWAN REIT.
(Source: Portfolio Visualizer) PSA = portfolio 1
Over the last 20 years, Public Storage has managed to outperform the S&P 500 across all rolling time periods and nearly triple the market’s annual returns. But with two-thirds less overall volatility, a smaller peak decline (Financial Crisis when all REITs got gutted) and a 133% better reward/risk (Sortino) ratio which measures total returns minus risk-free Treasury yields divided by negative volatility (the only kind investors care about).
And income investors will be happy to know that Public Storage, while not known for its annual dividend raises (it sometimes goes several years without a hike), was one of just 13 REITs to avoid cutting or suspending its dividend during the Great Recession (87% of REITs cut due to excessive leverage and credit markets freezing up).
Now I’m not saying that Public Storage is guaranteed, or even likely, to repeat its impressive 15.5% CAGR run over the next 20 years (past performance is never a guarantee of future results). But from today’s valuation, and given this REIT’s realistic long-term growth runway and outlook, I expect Public Storage to generate safe and recession-resistant dividends as well as approximately 7.5% total returns over the coming five to 10-years (matching or beating the market’s 4% to 7% expected returns).
That potentially makes it a good addition to a diversified and well-constructed portfolio that’s most likely to help you achieve your long-term financial goals.
Photo Source
Public Storage: Great Business Model + Great Management = A Recession-Proof SWAN You Can Trust Founded in 1972, Public Storage is the oldest and largest storage REIT in America, with 2,444 facilities in 38 states representing 164 million rentable square feet of space serving about 1.5 million customers. The REIT also owns 35% of Shurgard Self Storage (European storage company with 231 facilities in seven Western European countries) and 42% of PS Business Parks (PSB), which owns 28 million square feet of premium commercial office space.
When analyzing any dividend stock I consider three crucial factors to long-term success. These I use to create a quality score, which I use to determine the overall quality of a business, and thus what total return/valuation is appropriate for recommending to readers (or buying for my retirement portfolio, where I keep 100% of my life savings).
Dividend Safety: 5/5 (excellent)
Business Model: 2/3 (average to above average)
Management Quality: 3/3 (excellent)
Quality Score: 10/11 (SWAN)
First and foremost I need to know the dividend is safe and likely to be maintained or grow through the entire economic cycle (including recessions). Which is why a safe and stable payout ratio is important.
(Source: Simply Safe Dividends)
Public Storage’s payout ratio is safe for its industry and business model (more on this in a moment) but has been rising over the years courtesy of the dividend outgrowing AFFO/share (REIT equivalent of free cash flow and what funds the dividend). Based on FFO/share, PSA’s payout ratio is an even safer 70%.
Another important safety factor is the balance sheet since REITs are naturally a high leverage sector and it was excessive debt that forced 87% of REITs to cut during the Great Recession.
(Source: Simply Safe Dividends)
Public Storage has the lowest leverage ratio I know of as far as REITs go, thanks to management’s use of low cost preferred stock over the past decade. Its debt/capital ratio is just 13% (sector average about 50%) and the interest coverage ratio is sky-high at nearly 50.
This explains why Public Storage has an “A” credit rating from S&P (one of just nine A rated REITs) and average borrowing costs of just 2.3% (some of its debt is European, where rates are virtually zero). For context, according to Treasury Direct, in May 2019 the average borrowing cost for the US Treasury was 2.6%, showing that Public Storage’s bank vault safe balance sheet gives it access to some of the lowest cost capital in all of REITdom.
Now it’s true that in the future those costs are likely to rise because management says it’s likely to use more long-term debt vs. preferred shares. But I’m confident that Public Storage will retain its A rating and always retain its famously conservative and safe use of debt.
That’s courtesy of the excellent management team led by CEO Joe Russell. Russell became CEO in January 2019, but has a great and long track record with Public Storage, serving as CEO of PS Business Parks from 2003 to 2016 and was its president since 2002 (he became President of PSA in 2016).
Skilled capital allocation and a corporate culture that favors safe dividends are what I look for, and PSA’s has shown it can be trusted to steward shareholder capital well. For example, following the Financial Crisis commercial real estate investment, including in storage, collapsed, created great opportunities for profitable acquisitions of storage properties.
(Source: Hoya CApital Real Estate)
PSA put its large cost of capital advantage to good use, making $938 million in acquisitions in 2013 alone, and at attractive cap rates.
(Source: Marcus & Millichap, Hoya Capital Real Estate)
But since then relentless supply growth and falling cap rates (storage was one of the hottest sectors until 2016 causing investment spreads to decline by 2.2%). This has caused management to wisely pull back on acquisitions and instead focus on accretive organic growth, targeting supply-constrained areas that have the best growth potential (such as New York and Florida).
Which brings me to the final reason to like Public Storage, the recession-resistant business model and good long-term growth opportunities.
While REITs are usually sensitive to the state of the economy, storage has historically not been. During the Great Recession, the industry’s cash flow declined just 5%, according to a report by Bank of America, and that was during the worst economy since 1946.
Which is why in 2008, when REITs fell 37%, Storage was the only REIT industry to post a gain (5%). That’s because of the excellent core fundamentals of shelf storage which include very low operating costs. Most storage REITs can be cash flow positive at just 30% occupancy and Public Storage needs just 5,600 employees to operate over 2,400 locations. Management expects long-term occupancy will range between 93% and 95% over time (it’s 92% right now), meaning its facilities will be cash flow minting machines (70%-plus operating margins).
40% of its cash flow is from California, Texas and Florida properties, with its most profitable business being in California, particular San Francisco and LA (25% of its cash flow). Severe zoning restrictions (NIMBYism) and high land costs make it expensive to build new storage facilities, placing an artificial cap on supply that gives PSA stronger pricing power than other markets due to approximately 22% market share in those two cities (several times larger than its nearest rivals).
Combined with its strong brand and industry-leading advertising budget (including digital which drives 70% of new customer acquisitions), Public Storage has shown itself to be able to raise prices consistently over time, though that will likely slow in the future (see risk section).
And while true that storage leases are not long term (month to month), according to PSA, 60% of customers stay for at least a year, and industry wide 40% of customers stay for at least two years. Most people are loath to cancel because it means a major hassle. Emptying a storage locker (average industry cost $90 per month) usually requires renting a truck and then taking a full day to move your stuff (and most people don’t have room for their excess possessions in their homes).
Since the average annual rent increase is 8% to 10% (in recent years) that's a lot of time and effort to save $10 to $15 per month, which is why most people just keep their storage units, even if they aren’t necessarily needed. Over the long term analysts expect storage REITs to retain 4.5% annual pricing power, which should allow occupancy to remain at 90%-plus, three times the breakeven levels.
As for long-term growth opportunity, Public Storage has a solid growth runway for cash flow and dividends in the coming decades.
From 2012 to 2060 the US Census Bureau estimates the US population will grow by 50 million. And retirees are increasingly downsizing to smaller homes and need to put their stuff somewhere, creating two long-term catalysts for the storage market.
And then there’s the fact that its three largest markets (40% of rent) are expected to grow at rapid rates as well.
California 10% population growth from 2020 to 2030
Florida 15% population growth from 2020 to 2030
Texas 18% population growth from 2020 to 2030
US population growth 7% from 2020 to 2030
There's also the possibility of growth through opportunistic acquisition, such as merging with the other four major storage REITs (or future acquisitions at higher cap rates). The top five storage REITs control just 12% of the market and PSA’s share is just 6%.
Valuation/Total Return Potential: At Essentially Fair Value Public Storage Is A Decent Buy...BUT You Need To Have Realistic Expectations It’s important to remember that total returns are a function of three things: Yield, long-term cash flow/dividend growth (which drive intrinsic value and share prices) and valuation changes.
Thus a good dividend growth stock will offer a good combination of the three to hopefully deliver market-beating returns as well as safe and growing income over time.
We’ve seen that PSA’s dividend offers excellent safety, courtesy of that bullet-proof balance sheet, good payout ratio, and recession-resistant cash flow. As I’ll explain momentarily, long-term growth is likely to be about 5% over time, which brings us to valuation.
There are many ways to value a REIT, but historically the most useful are price to cash flow, yield vs historical norm (dividend yield theory, beating the market since 1966), and a conservative discounted cash flow model such as what Morningstar uses.
P/FFO: 22.2 (vs 20 year average of 18.9 and 5-year average of 22.2)
Yield: 3.4% (vs 5-year average of 3.5% and 3.0% 13 year median yield)
Morningstar estimated fair value (conservative DCF model): $226 (5% overvalued)
My estimated fair value: $230 (3.5% yield, 3% overvalued)
Right now Public Storage is trading at 22.2 times FFO, right at its five-year average, though slightly higher than its 20 year average of 18.9. Given that low-interest rates are expected to persist for the foreseeable future (bond futures market pricing in low inflation for the next 30 years) I assume that PSA’s average P/FFO ratio will be between those two figures, roughly 20.6.
Similarly, I expect low-interest rates to mean an average/fair value yield of approximately 3.25%, which when averaging with Morningstar’s estimate intrinsic value of $226, gives me an estimated fair value of $230 (3.5% yield).
Based on my personal blue-chip valuation scale, that makes PSA, at 3% overvalued, close enough to fair value to still potentially recommend buying today (though watchlisting it's also appropriate if you want to prioritize more undervalued blue chips).
That’s based on the Buffett principle that it’s “far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” I consider level 10 quality PSA a wonderful company and so buying today is still likely to generate close to market returns or slightly better.
(Source: F.A.S.T Graphs)
Assuming PSA trades down to 20.6 times FFO within five years that would mean a total return of about 6.7% over that time, based on consensus analyst growth estimates which I consider reasonable based on the medium-term growth outlook (see risk section).
Yield: 3.4%
Long-Term expected FFO and Dividend Growth: 4.7%
Expected Total Return (No Valuation Changes): 8.1%
Actual Total Returns Expected (factoring in valuation and model’s 20% historical margin of error): 6.0% to 9.4%
My long-term (5 to 10 year) valuation-adjusted total return model is based on what Brookfield Asset Management (BAM) and NextEra Energy have used for decades (and based on a model that’s proven effective since 1954). My model estimates that total returns = yield + long-term cash flow growth plus valuation returning to fair value over five to 10 years.
The 20% historical margin of error (based on dozens of dividend stock and ETF backtests spanning decades) means I expect PSA to deliver 6% to 9.4% total returns over that time period. That sounds pretty low compared to the stock’s 20-year returns or the market’s 14% CAGR over the past decade. But it’s actually pretty good given the low expectations most asset managers have for the S&P 500 going forward.
Asset Manager Forecasts For Stock Returns Over Next 5 To 10 Years
(Source: Morningstar Survey)
Basically, Public Storage offers conservative income growth investors a safe 3.4% yield, with market matching (or slightly superior) total return potential, all in a recession-resistant, low volatility package. That makes it a “buy” today as long as you have realistic growth expectations, are comfortable with its risk profile and remember to use good risk management.
Risks To Consider
(Source: Hoya Capital Real Estate)
2011 to 2016 was a golden age for storage REITs, courtesy of capex spending falling off a cliff during the Financial Crisis. By 2016, when NOI growth peaked at 12%, the sector’s cash flow was growing three times faster than the REIT sector overall. But that has attracted massive supply growth that has caused much slower revenue, NOI and FFO/share growth.
(Source: Hoya Capital Real Estate)
PSA, while enjoying the highest rent/square footage in the industry (thanks to 25% of its rent being from San Fran and LA properties), is seeing the slowest growth in the industry, which itself is expected to grow much slower in 2019.
(Source: Hoya Capital Real Estate)
The good news is periods of weak profit growth self-correct supply issues and new construction on storage has moderated, helped by rising construction costs. While the industry is expected to grow at just under 3% this year (PSA basically keeping up), in coming years growth is expected to rise to 4% to 5%, slightly better than the 3% to 3.5% the REIT sector is known for.
But there's another thing to consider with PSA, which dividend growth investors (especially fans of aristocrats and kings) might not like. As you can see, PSA, while offering a very safe dividend that never gets cut, isn’t known for clockwork-like annual payout hikes.
(Source: Simply Safe Dividends)
The dividend has been unchanged since Q4 2016, and it might not increase again for several years.
And as for the REIT’s long-term growth risks, it’s important to know that management’s strategy of targeting faster-growing markets (like NY, Florida and underserved areas like Kentucky) potentially means lower profitability, given that self storage is basically a commodity service, with little in the way of differentiation and low barriers to entry.
But even if you understand the short- to medium-term business model risks and are comfortable with them, good portfolio risk management is essential, because even time tested market-beating winners don’t outperform (or post positive returns) every year.
(Source: Portfolio Visualizer) PSA = portfolio 1
Like all companies (which are risk assets NOT bond alternatives) PSA can be volatile at times (though over time it’s a low beta stock). 15.5% CAGR 20-year returns were not achieved in a straight line, but rather by periods of weak or negative returns being overwhelmed by periods of monstrous single year gains that frequently compounded on top of each other.
(Source: Portfolio Visualizer) PSA = portfolio 1
But long-term returns are meaningless if you can’t emotionally (or financially) stand periods of gut-wrenching volatility, such as the 43% plunge during the Financial Crisis. PSA was underwater (relative to its record high) for 3.5 years. In fairness to PSA, the S&P 500’s two longest underwater periods were
November 2007 to February 2009 (peak decline 51%): 4 years 10 month recovery time
September 2000 to September 2002 (peak decline 45%): 6 years 3 month recovery time
Great returns over time require using good risk management and appropriate asset allocation to ride out periods of underperformance (which no stock portfolio can avoid).
These are the rules of thumb I recommend for most people, based on 24 years of investing experience, six years as a professional analyst/investment writer, and consulting with several colleagues in the asset management industry.
It’s also important to remember that my recommending PSA, or any dividend stock for that matter, is NEVER meant as a bond alternative but for the equity portion of your portfolio. If you’re lucky enough to live off safe dividends alone? Well then you are the exception, but most people, especially retirees, plan to use some form the of the 4% rule. This means they need to sell portfolio assets to pay the bills, even during corrections and bear markets.
PSA Balanced Portfolio Allocation
(Source: Portfolio Visualizer)
This is where bonds and cash equivalents (like T-bills) come in. These are countercyclical to stocks, meaning they remain stable or go up in value during market downturns. Cash and bonds are what you sell using the 4% rule (or whatever percentage you are using) instead of stocks that can trade at ridiculous valuations at times.
Here I offer an example balanced portfolio that uses the standard 60/40 stock/bond portfolio the 4% rule is based on. I allocated 10% to PSA with 50% in the Vanguard Dividend Appreciation ETF (VIG), a good proxy for dividend growth stocks. I then split 40% bond allocation between T-bills (low-interest rate sensitivity), and overall US investment grade bonds (BND), and long-term US Treasuries (a low-risk hedge against sharp market downturns).
Yes, long-term rates are very low, but as you can see US Treasuries have a strong negative correlation to stocks since 1994. During a recession, Fed bond buying (which Chairman Powell recently confirmed is coming during future downturns) means that long-term rates might fall much lower (in Europe 30-year yields are near zero thanks to QE).
So let’s take a look at how this example balanced portfolio would have performed historically, including during the second worst market crash in history, and compared to a standard 60% S&P 500 and 40% bond portfolio.
PSA Balanced Portfolio Returns Since January 2008
(Source: Portfolio Visualizer) - annual rebalancing
This model portfolio outperformed its balanced benchmark over the last 11 years and across all rolling time periods. What’s more the peak decline during the darkest days of the Financial Crisis was just 21%, ⅔ smaller than a normal balanced portfolio. More impressive is that this portfolio, despite outperforming its benchmark by 17% annually over 11 years, did so with 14% less volatility. Its risk-adjusted (total returns/volatility) return was 36% better and its reward/risk ratio (excess total returns/negative volatility) was 39% better than just owning 60% S&P 500 and 40% the overall bond market.
What does that mean for retirees using some form of the 4% rule (ie most people)?
(Source: Portfolio Visualizer)
Over the past 11 years, you could have safely withdrawn as much as 12% of this portfolio without running out of money, slightly more than the standard 60/40 portfolio. More importantly, even with weaker returns likely in the future, the safe perpetual withdrawal rate is 5.7% for this portfolio, fully 1% higher than the standard balanced approach.
This shows how good risk management, including owning quality dividend growth SWANs like PSA, can be the superior means of achieving your long-term financial goals, such as a comfortable retirement.
Bottom Line: While Public Storage Isn’t For Everyone, It’s A Proven Recession-Proof SWAN Income Investors Can Trust
By no means do I intend to imply that Public Storage is a “must own” stock for everyone, nor that it’s going to come close to delivering its 20-year historical returns.
This REIT is famous for great management, that is super conservative with its balance sheet, and thanks to its recession-resistant business model, has delivered safe dividends in all economic/market conditions for over a quarter century. While the dividend grows at a decent rate over the long term, investors need to be comfortable with long stretches of frozen payouts, meaning PSA is never likely to become a dividend aristocrat.
But if you are comfortable with the lumpy nature of its payout growth, and don’t mind patiently waiting for its growth rate to accelerate to about 5% in the coming years, then today is potentially a good time to buy this level 10/11 SWAN stock at approximately fair value.
Doing so is likely to deliver a generous (relative to the broader market), safe yield as well as total returns over the next five to 10 years that should match or slightly beat the S&P 500.
Just don’t forget that no REIT is a bond alternative. So always use proper risk management and asset allocation that is most likely to fit your personal needs, and help you achieve your long-term financial goals.
Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.