NoDerog
At the start of the year I concluded that shares of Extra Space Storage (NYSE:EXR) were in need for extra space. The company has been a huge beneficiary of the self-storage boom which already started pre-pandemic, fueling massive rental growth in the process. Worrisome of the impact of higher interest rates and a potential pullback in demand I was cautious, even as shares were down substantially already.
A Recap
Founded in 1977, Extra Space Storage is a REIT which went public in 2004, having grown though organic growth and acquisitions. The company has grown to operate more than 2,300 properties by 2022, many fully owned and operated at the same time. With a portfolio of around 175 million square feet and over 1.6 million units, these are literally just garage boxes (or smaller) with average square footage around 100 feet. Located in major metropolitan areas, the company actually employs 4,000 workers, many used for actual operations.
The company competes against the likes of Public Storage (PSA) which is similar in terms of size, as well as smaller competitors like Life Storage (LSI) and CubeSmart (CUBE). The company reported retention rates of nearly 50% on a two-year basis amidst short-term and flexible contracts, as overall occupancy rates have come in around 95%. Given the labor-intensive operations, scale and technology is key to make a difference.
Just a $12 stock at the time of the IPO in 2004, EXR shares hit the $100 mark in 2016, peaking at $220 in December 2021 amidst strong demand and low interest rates, with shares trading around 30 times Funds From Operations. The company has seen strong growth in 2022 as the balance sheet rose to $11.8 billion, financed with just $4.1 billion in equity.
Even as EXR stock was down to $142 in January this year, when I last looked at the shares, the market value has fallen to $20.2 billion, exceeding the book value by about $16 billion. This means that the book value of nearly $12 billion has risen to $28 billion, a huge number in relation to $1.9 billion in revenues, with realistic earnings seen around a billion following depreciation charges. This makes the valuation rich, although a $6 per share dividend started to provide quite some appeal, offering a 4.2% yield at the time.
Believing that the self-storage space has been one of the REIT sectors which has benefited the most from the pandemic, I was naturally cautious. Contrary to other parts of real estate, this is really about land, good positions and valuable places, with underlying value of the real estate not that high. With consumers hurt by inflation and cutting back on spending, the self-storage space might be seen as a luxury item (at least to some), which makes me cautious here given that these are short-term contracts.
What Happened?
Since I looked at Extra Space Storage at the start of the year, as well as some other self-storage REITs, we have seen quite some developments impacting the sector. In February, peer Public Storage announced its intention to acquire Life Storage in an all-stock deal in which investors in Life would get 0.4192 shares of Public Storage, in a deal valued at around $11 billion.
For Extra Space Storage, the year started relatively uneventful. The company announced an 8% hike in its quarterly dividend to $1.62 per share, in order to make the dividend yield more competitive versus risk-free rates. In February, the company reported a 22% increase in core Funds From Operations for the year 2022 to $8.44 per share. The company guided for flattish 2023 performance, arguably the result of higher interest expenses, with FFO this year seen between $8.30 and $8.60 per share.
Besides higher interest expenses, the company expects that expense growth (at 5.5%) is set to outgrow revenue growth by around a percent. Higher financing rates are confirmed by a bond issue in March, as the company sold half a billion in 2028 notes carrying a 5.7% coupon just below par.
With 144 million shares now trading at $160, marking decent 10% gains since the start of the year, the company commands a huge $23 billion equity valuation, or about $30 billion enterprise valuation.
With peer Public Storage going after Life Storage, Extra Space got involved with the bidding war in April. The company has offered 0.8950 of its own shares for each share in Life, valuing equity of Life at $145.82 per share. The deal is very large, as the exchange ratio would give investors in Life a combined 35% equity stake in the business. The company suggests that this is a done deal already, citing unanimous board approval from both parties, but one should note that unsolicited offers might be(come) a reality.
The company points towards growth and a resulting $100 million in operating synergies. That sounds like a very ambitious number in my book with revenues from Life Storage coming in around a billion. With Extra Space operating with 144 million shares outstanding ahead of the deal, the pro forma share count will rise to some 221 million shares. This suggests about a $0.45 per share (pre-tax) earnings contribution, but that is a big if as the $100 million synergy target looks ambitious.
The big winners in all of this are arguably the shareholders in Life, whose shares have risen from $100 in January to $122 when Public Storage made the (initial) offer as shares rose to the $140 mark upon the involvement of Extra Space Storage, with shares trading at a small discount compared to the offer being made. This arguably relates to time until, and uncertainty of deal closing, despite the potential for a bidding war.
And Now?
The reality is that I am a bit cautious here. Shares of the sector, including Extra Space, have done alright since the start of the year despite higher (short-term rates) albeit that long-term rates have come down. Valuations look a bit rich as the prospects for a bidding war appear real and that is not necessarily good for Extra Space of course.
That being said, industry consolidation in the long run should help the pricing power of the business, but there are many moving parts here. For now, I see no reasons to get involved with the shares of these players, although I will watch how the development pans out with great interest going forwards, before potentially reconsidering my neutral position.
