Shares of Extra Space Storage (NYSE:EXR) have been a significant underperformer this year, losing about 2% of their during a strong equity market. High interest rates continue to weigh on real estate valuations, and the self-storage face has also faced excess supply challenges. I last covered EXR in December, rating shares a sell, arguing fair value was in the $137-$149 range. Since then, they are flat, missing out on the market’s 13% rise. Given this underperformance, now is a good time to revisit Extra Space.
Extra Space last reported earnings on April 30th, and it generated $1.96 in core funds from operations (FFO), beating consensus by a penny. Results were down 3% from last year as the company faces margin pressure. Additionally, it had a $53 million increase in interest expense, given higher rates and increased debt from its acquisition of Life Storage, which has reduced FFO. Importantly, the impact of higher rates is now largely felt in its income statement, and we are starting to see improvement from its Life Storage acquisition.
The self-storage sector is not very concentrated, with about one-fifth of the industry managed by sub-scale operators. EXR is now the leading individual player, but it still controls less than one-seventh of the market, and it has high-quality operations. This lack of concentration and increased supply has weighed on industry occupancy and rental rates. That is why once-booming markets like Florida are now weak, as supply has come as demand has softened. Notably, Florida and Texas are each 13% of EXR’s revenue, with California next at 12%. Importantly, with its large-scale, EXR has managed through this period of volatility, and we are seeing signs the business may be turning.
Extra Space’s same-store revenue rose by 1% from last year. This was partly driven by improvement in occupancy. On average, occupancy rose by 30bp to 93.1%. At the end of the quarter, EXR had a 93.2% same-store occupancy from 92.7% last year. Realized same-store per unit rents were up about 0.6%, quite muted still. On the plus side, its move-in rate is up 8% from its seasonal January low, which does suggest that pricing trends are improving. EXR continues to see lower move-out or “vacate” rates than pre-COVID, but they are below pre-COVID peaks when some consumers were likely stuck with storage units for longer as moving plans fell through.
While it is encouraging to see top-line growth and improving occupancy trends, the business is facing margin pressure. As a result, same-store net operating income (NOI) fell by 0.5%. That is because same-store operating expenses rose by 5.5%. I do not view this as a sign of poor expense management, indeed corporate G&A has outperformed expectations. Much of this expense increase is out of management’s control. For instance, insurance is up 34%, an outsized increase, in part because CA and FL, two of its leading markets, have seen dramatic rate increases given wildfire and hurricane costs. With 2021-2022 policies now having lapsed, I do expect the rate of increase to slow. On the bright side, property taxes are up a more modest 1.7%. Given the tight labor market, payroll was up 9%, and with wage growth moderating, this should slow somewhat.
I would also note marketing rose 23%. I see this tied to its occupancy gains, with EXR working proactively to raise brand awareness and bring in customers. Importantly, the momentum from these efforts appears to be continuing. April occupancy ended at 93.7%, a further 50bp increase. EXR achieved this with sequential rate improvement, an encouraging trend.
Elsewhere, there is encouraging news on its Life Storage acquisition. A key rationale for this purchase was that EXR achieves higher rates and occupancy on its footprint, and by managing LSI stores as well as EXR ones, it could achieve revenue synergies. While I had some caution about the feasibility of this plan, we are seeing real progress. Legacy Life Storage same-store revenue was up 1.7%. Occupancy at these stores rose to 92%, up 220bp. They now lag EXR locations by just 90bp in April from 400bp at closing. Management has kept rates at Life Storage lower to boost occupancy first, aiming to bring parity in rate over time. How quickly EXR can boost rates without increasing churn is not certain, but the first step in this strategy is working well.
EXR is seeing ongoing gains in its capital-light outsource management business. It added 97 stores as part of its third-party management platform. It now manages 1,881 stores, and this growth was a bit ahead of expectations. Overall, it has kept full-year guidance broadly unchanged, with a midpoint of $8 in FFO. It does see ongoing G&A savings and now expects about $177 million from $181.5 million in G&A expense; offsetting this, interest expense could be a bit higher given rates are staying higher for longer.
Short-term rates do not have a dramatic impact on its financials because, including derivatives, 83.7% of debt is fixed rate. It has a 4.9-year average maturity on its debt, reducing annual rollover risk. EXR carries $11.1 billion of debt, which is about 6.3x FFO. I view this as a broadly healthy level, neither over-levered nor debt-light. As such, EXR has both a $500 million repurchase authorization and an $800 million of equity at-the-market (ATM) issuance program. It is unusual for a company to have the ability to both buy and sell shares. During Q1, it did neither, and I do not expect it to do either material issuance or repurchases given its solid balance sheet position. It does pay a $1.62 dividend, giving shares a 4.36% yield.
Coming into 2024, I expected about $8.15 in FFO—the high end of its current guidance. I still view this as a reasonable central case. We are seeing solid improvement in Life Storage results, and I am encouraged to see that occupancy appears to have already bottomed. On the earnings call, management made clear they were pleased with Q1 trends but hesitant to move guidance yet because Q2 and early Q3 are its most critical selling season. 51% of its customers are moving homes, and more people tend to buy homes and move in the spring and summer, making this a critical few months. These buyers will often use self-storage during and after a move. Right now, the housing market is relatively quiet, and management guidance assumes housing trends continue as is. EXR is not seeing a “major rebound.”
If we see improvement in housing, though, EXR could later boost guidance. Looking at existing home sales, it does appear we have hit the bottom, absent a surprise recession, but it is also fair to say there is no major rebound happening either. With mortgage rates likely to stay in the 6.5-7.25% area in my view, I am expecting a 0-5% rise in existing home sales this year, which may lead to modestly better demand for EXR. Combined with its expense discipline, this leaves me expecting FFO to be in the top half of guidance this year.
While interest rates have limited direct impact on its business, as discussed in December, they do drive EXR shares. That is because interest rates drive real estate valuations, and higher rates reduce the attractiveness of dividend stocks. This was a source of my caution several months ago. The correlation between rates and EXR is quite high. I would note in recent months while they still move in sympathy, EXR has outperformed long-dated treasury yields (TLT), as its operating performance has shown signs of bottoming.
With occupancy rising and Life Storage stores performing better, some of this outperformance is merited. However, if we do see long-term bond yields rise again and the 10-year treasury moves back up toward 5%, I would expect EXR to sell off. Conversely, if bond yields fall below 4%, EXR would likely outperform. Interest rates can drive the stock in the short term. However, I am growing more comfortable with EXR reporting sequentially improving results and returning to growth in 2025. With the ability to recapture some margin and get incremental gains from its Life Storage units, I see EXR able to grow its dividend by about 3-5% per year, due to ~2-4% NOI growth and 1-2% store count growth and solid 1.25x coverage today. With its 4.4% starting yield, EXR can generate ~8-9% long-term returns, broadly consistent with the market. This is a bit below my 10% hurdle for a “buy” rating, but after its underperformance and with improving results, a sell is no longer appropriate. Accordingly, I am upgrading shares to a “hold,” and I would be a buyer if we see shares pull back into the $145 area.
