Self storage real estate investment trusts (REITs) have been excellent investments over the long term. The group has outperformed the market by a wide margin since NAREIT began tracking data in 1994. One of the biggest drivers has been the strong performance of Extra Space Storage (NYSE: EXR) in the last decade, as it was the top REIT stock during that period.
Unfortunately, the past couple of years have been a different story. Self storage REITs lagged behind the REIT sector last year and have produced a negative total return in 2020. However, while the recent past hasn't been that great for the group, next year could be much better. Here's why.
Battling Through Another Tough Year
The self storage industry has been battling overcapacity issues in recent years because publicly traded REITs and private operators continued building new storage facilities, which has impacted earnings growth. For example, leading self storage REIT Public Storage (NYSE: PSA) only grew its funds from operations (FFO) per share by 1.2% last year, partly because it spent 40% more on marketing as it tried to wrestle customers away from its competitors. Extra Space Storage did a little better, as its FFO rose by 4.5% despite the significant increase in new supply.
Those new supply headwinds have remained in full force this year. On top of that, the industry has had to battle the impact of COVID-19. Those two issues caused Public Storage's FFO to slip 2.7% during the first half of this year, due in part to higher operating expenses and the write-off of some late fees to assist its tenants during the pandemic. Meanwhile, Extra Space's FFO improved by 4.5%, but its same-store revenue and same-store net operating income (NOI) declined due to the headwinds facing the company because of the pandemic.
A Rebound Ahead?
While the past couple of years have been challenging for the sector, venerable investment bank Goldman Sachs (NYSE: GS) sees better days ahead for publicly traded self storage REITs. A research analyst for the bank recently released a positive report on the sector's prospects for 2021.
One of the big catalysts the analyst saw for the coming year is the expectation that new supply growth will slow. Public Storage's CEO, Joe Russell, discussed this topic on that company's second-quarter conference call. He noted that "there is still a healthy amount of supply that continues to be delivered into 2020." However, he also stated that "we talked about the likelihood that it would be anywhere say 15% to 20% or so less than what was predicted, which would point to plus or minus at $5 billion or so level of deliveries in 2020. We think that's probably closer to $4 billion or less."
He further commented on 2021 and beyond by noting that "there will likely be more constraints around funding that many of these developers look for relative to construction loans," due to COVID-19. Because of that, he commented, "We're likely to see, again, another leg down. I don't know how hard and dramatic that might be. But it would be a welcome relief, particularly in the markets that we've been pointing to over the last couple of years that have been hit heavy with new supply."
With the supply headwinds likely fading next year, along with the additional ones relating to COVID-19, self-storage REITs should enjoy stronger market conditions in 2021. That leads Goldman Sachs to believe that they can quickly boost their rental rates as market conditions improve since they don't typically lock in long-term leases with tenants. As a result, they should see stronger FFO growth.
Better Days could Lie Ahead
The building boom in the self storage sector seems to be nearing an end, which is great news for publicly traded REITs. As the market finally starts absorbing this supply, these REITs can reduce their marketing spend and raise rental rates, which should boost FFO. That has the potential to reverse the recent underperformance in their stock prices, making the sector look like a compelling opportunity for REIT investors in the coming year.
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