3 Reasons to Sell This Red-Hot REIT

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Real estate investment trusts have seen better days. After climbing through May, an increase in interest rates sent most REITs back off their lofty valuations.

One REIT hasn't stopped popping, however. So far this year, Public Storage is up more than 15%. The broader REIT market as measured by Vanguard's REIT ETF is up only 3% this year.

PSA Chart

PSA data by YCharts.

This level of outperformance may not be sustainable; here are three reasons why:

1. Operating performance can't get much better
Public Storage's stock price has risen on the back of increased occupancy, better pricing, and improved profitability. As of the last quarter, Public Storage's same store occupancy rate rose to 94%, up from 92.4% in the year-ago period. 

Self-storage facilities have a natural level of vacancy of about 1 month per year, or 8.25%, due to customer churn. Given Public Storage's high occupancy rate for its established centers, future occupancy improvement will be limited. Each marginal customer is much more profitable than the last customer, but Public Storage's growth is capped by its occupancy rate.

2. Cap rates are coming down
The Wall Street Journal reports that cap rates, or returns on self-storage properties, have fallen precipitously from 9% during the financial crisis to as little as 5.5% for recent sales. Acadia Realty Trust sold a self-storage facility at an implied cap rate of 5.5%, which doesn't leave much room for above-market returns for the acquirer. 

Low cap rates require a new manager to raise rental costs and drive up occupancy to deliver returns for investors. In short, sale prices reflect that public storage companies can and should be able to raise prices and occupancy significantly each and every year after acquisition. 

3. Development is making sense again
When cap rates fall to yields you'd expect from investment-grade bonds, not equity REITs, new builds become more attractive. In a highly fragmented industry like self-storage, where Public Storage controls only about 5% of the industry, competitors can pop out of the woodwork quickly in hot markets. That could erode some of the pricing advantage going forward. 

Remember, self-storage is a relative commodity where companies compete primarily on price. There are no barriers to entry keeping out new self-storage facilities. All it takes is the desire and a stockpile of cash to build more storage space, as evidenced by the fact that storage companies have traditionally been owned by "mom-and-pop" operators.

The Foolish bottom line
The self-storage industry has enjoyed a wave of increased occupancy and rental increases that cannot be reasonably forecasted into the future. Public Storage's sky-high occupancy level of 94% and impressive annual rental increases are the product of a constrained market that likely won't be a "new normal" for the long term.

Self-storage companies probably won't be able to meaningfully grow earnings by acquisition with cap rates of less than 6%. Thus, we could only expect that companies will build out new self-storage developments, driving up supply, and compressing price increases.

Finally, a current dividend yield of less than 3% is little to get excited about when other equity REITs and Public Storage's own preferred stock offer yields in excess of 5%-6% per year. 

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The article 3 Reasons to Sell This Red-Hot REIT originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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