These Big Dividends Face Big Challenges

Source: Daniel Oines.

Just a mile south from my home, you'll find a relic of the past -- an old shopping mall.

It features most of what you'd expect in an old mall. A Sears store sits off to one side. The food court is drafty and awkwardly empty. A call center, a medical administration office, and a bar are its biggest tenants, but they're hardly a mall's bread and butter. These renters aren't the typical mall leaser; they're just looking for cheap rents.

And cheap rents is what you get when mall traffic slows to a standstill. In recent years, suburban sprawl and a higher-trafficked mall just two miles down the road have chipped away at its core tenants. It looks like nothing can truly revive its former stature. In the 1960s, it was bustling. Today, it's simply worn out its welcome.

Is this the future?
My story is purely anecdotal, but I can't help but think there are many millions of square feet of real estate that will be unlocked over the next few years. We've seen several retailers clawing back their store counts and laying off staff.

Online retail is crushing high-cost, offline retail. The casualties extend far beyond the retail sector to commercial real estate, where malls have dealt with higher-than-average vacancies during and before the great recession. Malls seem like a good short -- perhaps the Internet can displace them in their entirety. But mall REITs aren't my focus today. I'm looking at the most commoditized of real estate -- storage REITs like Public Storage and Extra Space Storage .

What's at risk?
When it comes to real estate, self-storage is about as commoditized as it gets. Customers care only about a few things -- the security of their personal belongings, the relative distance to their home, and the price.

The name on the building means very little. This is, after all, a commodity good. It makes sense to shop around for the cheapest price.

Alas, self-storage companies have been on a tear. Public Storage and Extra Space Storage have logged truly remarkable 10-year performances. On a total return price basis, shares are up 509% and 392%, respectively.

PSA Total Return Price Chart

Backing these impressive returns is the notion that self-storage growth has been minimal since the great recession. It has. New construction in the self-storage space has only recently hit a four-year high. In 2011, spending on self-storage projects was $241 million. In 2013, it was $530 million. Both years were still well off the peak spending of $1.2 billion in 2007.

Supply and demand dictates pricing, and with only minute amounts of capital flowing to self-storage companies, pricing has recently been in their favor. This partly explains why Public Storage and Extra Space Storage trade so expensively, at 22 and 25 times funds from operations, respectively. Investors are willing to tolerate sub-5% FFO yields in exchange for the potential of high-flying rents on the back of lower supply. If Public Storage and Extra Space Storage can continue to grow rents, they can grow into their higher valuations.

But for all the talk of a dearth of self-storage construction and renovation, little attention seems to be paid to a growing number of empty big-box stores, shopping centers, and malls, all of which can be turned into self-storage centers with the stroke of a pen and modest improvements.

I worry that investors are overlooking a bigger trend. Retail spaces of large sizes and potential for storage uses are freed up with every big-box store closure. These spaces have only a handful of end users -- other big-box stores -- which are, as a whole, shuttering stores, not opening them. Their users, and their uses, are thus limited. Without growth in big-box retail, who will fill them?

The obvious answer, in my view, is the self-storage industry. As these empty spaces come online, I find it difficult to believe basic economics won't negatively affect storage rents and the prospects for the self-storage industry.

Perhaps I'm just jaded by local anecdotes. But if there's one reason I'd never invest in a public-storage company, especially now, it's because it's difficult to quantify how the death of big-box retail will flow into other segments of commercial real estate. I'm not willing to take that risk, certainly not at 20-plus multiples of funds from operations. 

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