Public Storage (PSA): Down 17% But Still A Superb Dividend Growth Stock

Real Estate Investment Trusts, or REITs, are one of the most popular types of dividend stocks for yield-hungry investors, especially those living off dividends in retirement.

 

When it comes to REITs, few have done better for investors than Public Storage (PSA) over the years.

 

The company has continuously paid quarterly dividends since 1981 while generating excellent total returns for shareholders.

 

REIT	Total Return Since 2005	CAGR Total Return
Public Storage	569.2%	17.16%
Vanguard U.S. REIT ETF	192.5%	9.36%
S&P 500	166.6%	8.51%

Source: Ycharts

 

While you might think that the company’s strong long-term outperformance means that Public Storage is overvalued and should thus be avoided, a look at the company’s fundamentals reveals a best-in-class industry leader with plenty of growth opportunities left in the coming years.

 

Best of all, the recent REIT correction has sent shares down 17% since early July, possibly making for a great long-term buying opportunity for what is likely to continue to be one of America’s best dividend growth stocks.

 

Business Description

Public Storage was founded in 1972 and is America’s largest public storage REIT, owning over 2,500 storage rental properties (as well as business parks) in 38 states, and seven European countries. The company’s self-storage facilities serve over one million customers in total.

 

The business model provides great short-term visibility, with customers signing month-to-month leases. This gives the REIT excellent protection against inflation due to the ability to continually raise rents.

 

Business Analysis

Public Storage has become famous for its ability to continually raise rents, especially in key markets such as California where high land costs and restrictive zoning regulations prevent new supply.

 

Combined with a disciplined growth strategy that’s focused on gradual property growth, as well as aggressive expansion of existing facilities ($542 million into expanding its rentable square footage by 4.2 million square feet in the next two years), Public Storage has put up impressive growth, both in top line sales but also margin expansion.

 

 

Public Storage is a great company for several reasons, starting with the company’s sheer size. The business is larger than its top three competitors combined, which allows it to leverage its costs across the company to achieve better profitability.

 

Public Storage also focuses on major metropolitan areas with favorable demographics. These areas are characterized by better incomes, greater popular density, and faster growth rates. They also provide consumers with easier access to storage since they are conveniently located.

 

Public Storage has built up 20%+ market share in many of these cities and benefits from the high visibility its locations receive, further building up the company’s brand value and recognition. While barriers to entry are relatively low in this industry, it is harder for new rivals to enter major metropolitan areas because of higher property costs and increased zoning restrictions.

 

Self-storage warehouses are also attractive because they require very little costs to operate. Unlike most other types of buildings (e.g. offices and apartments), these facilities do not need carpet or furniture or much equipment that needs to be maintained.

 

They also require few employees to run them because they are largely self-serve, and much of the work needed can be automated (e.g. security cameras instead of security guards; online reservations). In fact, Public Storage has just 5,300 employees compared to its 2,500+ property locations.

 

As a result, once a storage facility reaches a high enough occupancy level, they generate excellent profit margins, have risk spread across a large tenant base, and require little maintenance capital expenditures to maintain their appearance. Unlike most REITs (and many other types of businesses, for that matter), Public Storage’s unique qualities have made it a free cash flow machine over the years.

 

 

As long as people continue experiencing major life events such as an unexpected move or divorce, there will be demand for self-storage warehouses.

 

In other words, the industry is very stable and predictable with a slow pace of change – all good things for long-term dividend growth investors. Public Storage’s warehouses pay for themselves and the land underneath them, which is quite valuable considering the company’s focus on major metropolitan areas.

 

Thanks to the industry’s largest economies of scale in terms of property management, maintenance, and advertising costs, Public Storage has some of the highest profitability of any REIT in America.

 

REIT	Operating Margin	Net Margin	Return On Assets	Return On Equity	Return On Invested Capital
Public Storage	53.4%	45.0%	11.6%	22.4%	21.03%
Industry Average	45.8%	32.0%	4.1%	8.9%	NA

Source: Morningstar

 

Even more impressive is that the company’s management team, led by CEO Ronald Havner, (who’s been in the top spot since the turn of the century), has been able to remained disciplined in the company’s expansion.

 

That means avoiding reaching for growth by overpaying for new facilities and maintaining the most conservative approach to debt of any REIT. And despite its large size, Public Storage has just about a 6% market share in U.S. storage facilities, which number over 50,000.

 

The self-storage market is vast in size but also incredibly fragmented. In fact, the top four operators have less than 15% of all facilities. In other words, there remains a very long growth runway for Public Storage to continue expanding and consolidating the market.

 

Key Risks

While there are plenty of things about Public Storage for dividend investors to like, nonetheless there are three main risks to consider.

 

First, it’s unlikely that management will be able to continue to maintain the sky-high occupancy rates of recent quarters (95%), especially with several years of aggressive rental increases under its belt.

 

Going forward, management expects occupancy rates to stabilize at 93% to 94%, and future rental increases are likely to be slower given the rising supply of new storage facilities (1,500 in 2016 and 2017), especially in key markets such as Florida and New York.

 

The self-storage market goes through ups and downs just like any other market. For example, read this excerpt from a 1990 article in The Los Angeles Times:

 

“Public Storage has struggled to attract investors to recent projects, owing to the sagging real estate investment market, lower yields on Public Storage’s deals and investor nervousness about Public Storage’s issuance three years ago of $135 million of junk bonds. The surge in competition has also made it harder for Public Storage to find new sites and to raise rental prices.”

 

As industrial real estate prices have increased over the last few years, Public Storage’s disciplined management team has done the right thing by refusing to chase overpriced growth opportunities.

 

However, that has resulted in fewer growth opportunities in recent years. Only continued strong pricing power has resulted in the kind of 11% AFFO per share growth that Public Storage reported thus far in 2016.

 

Essentially, investors need to be prepared for top line growth to slow to the high-single digits unless a decline in storage REIT prices allows management to acquire one of its major rivals such as Extra Space Storage (EXR), CubeSmart (CUBE), or Life Storage (LSI).

 

Finally, we can’t forget the elephant in the room, interest rates, which have risen by about 0.7% since November 8th, and might rise by as much as 3% over the next four years (according to the Federal Reserve’s projections).

 

Fortunately, Public Storage has very little debt for a REIT, so the concern here isn’t with higher interest costs. Rather it’s that preferred stock investors, who provide almost all of the REIT’s growth funding, will demand higher interest rates on future preferred shares.

 

After all, if risk-free 10- and 30-year Treasury bonds see their yields rise to 4%, 5%, or even 6%, then the days of Public Storage being able to lower its funding costs by refinancing its preferred shares with ever lower yields will be over.

 

In addition, while Public Storage’s dividend is among the safest of all REITs, nonetheless higher rates on U.S. Treasury bonds means that Public Storage’s share price might experience additional downward pressure, since investors almost always demand some kind of yield premium to compensate for the higher risk of investing in volatile stocks over Treasury bonds.

 

While that would be great news for income investors who have a long time horizon and can take advantage of these higher yields, short-term, risk intolerant investors such as retirees who need to sell shares to fund living expenses need to keep this share price risk in mind.

 

Dividend Safety Analysis: Public Storage

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Public Storage has a Dividend Safety Score of 93, making it not just an extremely safe dividend stock, but perhaps the safest dividend in all of REITdom. That’s because of two main factors.

 

First, Public Storage’s adjusted funds from operations, which it calls “funds available for distribution” and is the equivalent of its free cash flow, payout ratio for the last quarter and year-to-date 2016 is a conservative 72.8% and 76.5%, respectively.

 

While that may not sound all that low, keep in mind that because REITs are not allowed to retain lots of cash flow, the relatively “safe” range for a REIT’s payout ratio is typically around 80%, meaning that Public Storage’s dividend is truly rock solid.

 

High payout ratios create dividend cut risk if a company’s cash flow unexpectedly declines. Fortunately, the self-storage business has proven to be fairly resistant to economic downturns. While consumers spend less during recessions, they still need a place to store their stuff.

 

In fact, the self-storage industry’s free cash flow per share fell by less than 5% during the financial crisis, according to the chart provided in a 2013 report by Bank of America Merrill Lynch. PSA’s sales dipped by just 4%, 6%, and 1% in fiscal years 2008, 2009, and 2010, respectively, and the company’s stock outperformed the S&P 500 by nearly 50% in 2008.

 

 

Another key component to Public Storage’s dividend security is its industry-leading balance sheet. As you can see, the REIT has very low debt levels, which is impressive in a highly capital intensive industry such as this. The company has a debt to capital ratio of just 4% compared to the industry average of 48%, according to Morningstar, which helps explain its “A” credit rating from S&P.

 

 

The secret to Public Storage’s ultra-low debt is management’s penchant for raising growth capital not from debt or common equity (over the last five years, PSA has increased its share count by just 0.3% annually), but through preferred shares.

 

The benefit of funding growth this way is twofold. First, preferred stock isn’t debt, meaning that by relying on preferred shares the company keeps its balance sheet squeaky clean and thus maximizes financial flexibility into the future.

 

For example, if Public Storage wants to make a big game-changing acquisition, such as acquiring one of its larger rivals, its strong credit rating would allow it to take on a lot of very cheap debt (which management has said it plans to do in the future).

 

This would allow the company to grow without diluting existing common shareholders and would send its AFFO per share soaring, allowing for an even safer, and faster growing dividend.

 

The second benefit of preferred shares is that, unlike bonds, which eventually expire and need to either be repaid or refinanced (exposing the REIT to interest rate risk), preferred shares, especially those sold recently at rock-bottom yields, are potentially perpetual, meaning management has the ability to one day buy them back (i.e. pay them off) or not, depending on what interest rates are doing at the time.

 

In other words, Public Storage’s management has taken an ultra-conservative approach to debt that helps to maximize its long-term growth, results in an ultra-safe dividend, and will protect it should the corporate credit market ever freeze up, as it did during the great financial crisis of 2008-2009.

 

For all of these reasons, Public Storage has one of the safest dividends in the market.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Public Storage has a Dividend Growth Score of 81, indicating it has excellent long-term income growth potential.

 

The company has paid uninterrupted dividends for more than 25 years and increased its dividend every year since 2010.

 

As seen below, Public Storage’s dividend has grown by 13.1% annually over the last decade and by 13.9% per year over the last three years. Public Storage last increased its dividend by 11% in October 2016.

 

 

Of course, investing shouldn’t be done based on a rear-view mirror, but fortunately Public Storage, despite being America’s largest public storage REIT, still has plenty of growth left in the tank.

 

For example, while it is indeed the dominant market share leader on an absolute basis, the REIT still has plenty of room to grow its market share through continued opening or acquiring new properties.

 

For example, even in its major markets, the company does not have more than 30% market share.

 

 

When combined with its strong balance sheet and large amount of super cheap debt (untapped $500 million revolving credit facility), Public Storage appears to have more than enough dry powder to keep growing its AFFO per share and dividend by 8-12% for years to come.

 

Valuation

Because of the way REITs are set up for tax reasons, looking at EPS is largely a waste of time. That’s because the depreciation and amortization that GAAP accounting requires doesn’t apply to REITs, since the value of real estate generally increases over time.

 

In other words, EPS has no bearing on a REIT’s ability to pay or grow its dividend, which is the primary reason for owning this class of equities. Looking at the price/AFFO, as well as the yield relative to its historic norm, is a better way to determine if a REIT is trading at a reasonable price.

 

In the past 13 years, Public Storage’s dividend yield has ranged from 1.78% to 4.51% with a median of 2.8%. From a historical yield perspective, the REIT looks undervalued based on its current dividend yield of 3.7%.

 

However, the stock’s P/AFFO is about in line with its long-term average. At 23.3 times AFFO, PSA’s stock doesn’t look all that cheap today, especially if occupancy rates are topping out and near-term growth becomes more difficult due to increasing industry supply.

 

P / AFFO	Historic P / AFFO	Dividend Yield	13-Year Historical Median Yield
23.3	22.9	3.7%	2.8%

 

The company’s long-term outlook remains bright, and high-single to low-double digit AFFO per share growth wouldn’t surprise me as Public Storage continues consolidating the market. Under this assumption, PSA’s stock could offer double-digit annual total returns, but a 10%+ pullback in the stock would provide a larger margin of safety that I would be more comfortable with.

 

Conclusion

From an absolute perspective, Public Storage isn’t exactly dirt cheap and could still drop from here. Public Storage is a company I could certainly see myself owning in our Conservative Retirees dividend portfolio if the pullback in REITs continues or supply and growth concerns bubble up in the self-storage industry, causing a selloff in PSA.

 

Given the quality of the company, the disciplined management team, excellent dividend profile, rock solid balance sheet, and long growth runway, there’s not much to dislike about this premier REIT.