No More Moats in Self-Storage Stocks
After a recent rating change, we see no moats among self-storage stocks, but demand for self-storage remains strong.
After taking a deeper dive into the self-storage industry, focusing on how the efficient scale moat source applies to competitive dynamics, we have downgraded Public Storage’s (PSA) economic moat rating to none from narrow. Peer Extra Space Storage (EXR) already has a no-moat rating. The main reasons for Public Storage’s rating change were (1) moaty qualities related to intangible assets were identified in only 25% of the portfolio, while switching costs were determined to be too small to retain tenants; (2) new supply can easily challenge the company’s presence in less densely populated areas; and (3) occupancy is decreasing as competition pressures market share. Our fair value estimates stand at $229 per share for Public Storage and $85 per share for Extra Space.
The main differentiator between the self-storage companies we cover is that Public Storage focuses on a development strategy and owns or manages its own facilities, whereas Extra Space relies on acquisitions for rapid growth. Extra Space owns or has partial ownership in 1,000 facilities (750 owned and 250 joint venture) and manages 350 third-party facilities.
Despite the industry’s lack of a moat, we think demand for self-storage remains strong. However, we acknowledge that expansion will shift portfolios away from core West Coast assets that have supported steady rent increases over the past decade due to strict zoning laws and the lack of affordable space. Also, new opportunities will target less lucrative markets where self-storage providers have traditionally consisted of mom-and-pop shops.
While we view self-storage as an undifferentiated product, Public Storage and Extra Space both command slight price premiums to local operators as a result of quality, enhanced security, and better customer service. However, because of the additional costs involved and the fact that larger nonpublic peers can easily duplicate these advantages, this doesn’t translate into increased returns.
The self-storage companies we cover enjoy high returns in various California-based markets, but the competition is high in newly tapped regions where zoning laws and space constraints are not factors in preventing new supply. Although Public Storage and Extra Space rank first and second in rentable space, respectively, supply is easy to add in most markets--often in as little as one year--and can come from various providers in the extremely fragmented industry. New entrants can easily lure tenants away with attractive concessions, including free or discounted rent, reflecting a lack of pricing power for incumbent landlords.
We also point out that the core West Coast portfolio for both companies constitutes only 25%-30% of profits, leaving the bulk of the portfolio susceptible to increased supply. Developers realize the profitability of self-storage and are bringing more projects to market. Existing facilities can be run profitably with occupancy rates as low as 30%. We believe landlords will continue to push mid-single-digit rent increases on to customers for the next several years, although we project that occupancy rates will begin to decline in the medium term as supply comes on line by 2018.
Extra Space’s acquisitive strategy and higher reliance on debt is reflected in our high fair value uncertainty rating, while Public Storage earns a low fair value uncertainty rating for its fortress balance sheet and strategy to develop rather than purchase assets with prices at all-time highs.
Brad Schwer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.