Extra Space Storage: I'll Wait For An Even Better Price

Extra Space Storage Inc. (NYSE:EXR) is one of those REITs that you wish you could own for a good price.

For one, the size of this business is huge and has a good chance of getting even bigger in the long term. Additionally, the company has been increasing its dividend at a great pace for a very long time. I also appreciate that the profit sharing is being conducted at a conservative leverage level with plenty of liquidity, supported by the profitability of a fast-growing business.

Regardless, the premium to NAV, no matter how much the business deserves it and how historically low the price is, offers no margin of safety for cautious investors and traders. That is why I would personally avoid but definitely add this one to my watchlist for now. What follows is me explaining that decision...

Portfolio

Extra Space Storage is a well-established self-storage REIT that was founded back in 1977 and is headquartered in Salt Lake City, Utah. It owns 280 million sq. ft. of storage facilities in 43 states, spread over 3,666 locations.

Besides the REIT's huge size, the really attractive attribute is the diversification it offers. Operating in most of the country provides the company with a uniquely large market share:

But small enough to make growth at a decent pace still possible at the same time.

Performance

As of the end of the second quarter, the company's same-store square-foot occupancy was 94.5%, higher than the 2022 average of 92% of the properties in general.

Extra Space has also experienced fast growth in its operating results with a definitive trend in the past 10 years:

More recent performance verifies its growth momentum. The REIT generated $440.7 million in rental revenue during the last quarter, a YoY increase from $408 million. The figure also suggests increased profitability for its rental operations over the recent past with its last-quarter annualized figure coming at $1.76 billion and its past 3-year average at $1.38 billion.

However, this growth wasn't reflected in the operating income which was slightly lower during the second quarter than the one a year ago; $273.3 million vs. $275.6 million. Annualized ($1.09 billion), though, it is higher than the 3-year average of $897.4 million.

The same applies to funds from operations; slightly lower when comparing the YoY quarterly figures ($296 million vs. $303.58 million), but an increase was noted between the annualized $1.18 billion and the 3-year average of $965 million.

Leverage

What can provide even more confidence in the REIT's prospects than its past operating performance is perhaps the fact that it realized such growth with moderate use of leverage. Its total debt has increased over the past decade from 50% of its total assets to 60%.

It may appear high in absolute terms, but within the context of its rapid profitability growth and its preserved adequate liquidity all these years, I do not find this alarming.

Moreover, there are no maturities coming until 2025:

That may be enough time until the current situation regarding interest rates improves. As for the large portion that needs repaying in 2027, it's so far in the future that I cannot assess how well they will refinance it.

Dividend & Valuation

Currently, Extra Space pays a quarterly dividend of $1.62 per share which suggests a respectable forward yield of 5.32%. I strongly believe the dividend is sustainable here.

First of all, the distribution has increased by a total of 548% in the last 10 years; a phenomenal growth rate. This is not unreasonable given the company's fast growth over the same period as we observed above.

Second, its payout ratio for the year 2022 was at 68.47% based on AFFO and that assumes that all capital expenditures for the year were maintenance CapEx, so it's actually even lower than that.

Along with the prospect of further dividend growth in the future, EXR appears as a great pick for a dividend portfolio. However, investors must pay quite a premium for the intangible value of the management and prospects on top of the assets.

That is not adequately reflected in its P/FFO of 14.4, which is not terribly higher than the sector median of 11.30. But it is evident in its implied cap rate of 4.24%.

Even if cap rates have decreased even further than the all-time low of 5% recorded in the fourth quarter of 2022, it's unlikely that the difference would be sub-4% to present an opportunity.

Risks

Though it makes complete sense that you can't get EXR for a price below NAV, that doesn't change the risk that the premium represents. There is no margin of safety here.

To be fair, I doubt this is reasonably connected to a risk of long-term capital loss; there is a lot of evidence that makes this unlikely. I guess this translates more into an opportunity risk. We have to consider that over the last 10 years, the stock's price has increased more or less as much as the market, and its total returns are not that much higher to compensate for the risk of owning a REIT over the S&P 500.

At the same time, that comes down to what you require. If you value income over total returns, Extra Space Storage may be a decent option.

In any case, that's long-term. In the near term, you should also be mindful of another potential rate hike by the Fed before the end of the year. And given the fact that rates are likely to experience a slow decrease in the next one, the recent pressure on EXR may persist for quite some time; of course, I am looking forward to updating my thesis if the price drops significantly.

Investor Takeaway

All in all, I am impressed by the operational performance of Extra Space Storage and quite disappointed to see that its price isn't below fair value. Although I am used to looking at long-term trading opportunities when it comes to REITs rather than buy-and-hold investment ones, I think that EXR could have a place in my portfolio.

Just to be clear, I believe it's almost certain that the stock will deliver decent absolute returns to shareholders in the long term. And I wish good luck to any who have a position in it. I just personally put a great weight on valuation as I am looking to realize gains through inefficiencies. And there's nothing inefficient about EXR.

I wouldn't go as far as to call it overvalued either. I think that management has done a great job in maintaining a balance between growing the business and sharing profits with shareholders. Surely, this deserves a premium. But I am looking for stocks that deserve to trade close to fair value but instead trade significantly lower than that.

What do you think? Do you own EXR? Do you intend to or are you going to wait and hope for a greater fall? The floor is yours. I am going to try my best to answer your comments as soon as possible. Thank you for reading.